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Section 4. Understanding Nonprofit Status and Tax Exemption

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  • What does it mean to be nonprofit and tax-exempt?

  • What are the advantages of nonprofit and tax-exempt status?

  • What are the disadvantages of nonprofit and tax-exempt status?

  • When should you consider applying for nonprofit and tax-exempt status?

  • When you might not want to apply for nonprofit and tax-exempt status

  • How do you apply for nonprofit status?

  • How do you apply for federal tax-exempt status?

  • A last word on getting help

In any society, there are rules citizens need to follow. In a good society, these rules have been created to help things run smoothly, for the benefit of individuals and for the community as a whole.

As individuals, others help us learn these rules as we grow. Our parents are quick to point out that we must pay for the candy bar at the grocery store; we take courses in government in school; we register to vote when we turn 18; and as we agonize over our tax forms each April, we know where we can go for help, especially the first time we fill out the paper work and agonize over foreign terms such as "earned income credit" and "total taxable income."

Organizations are part of the community as well. They don't exist in a vacuum, and therefore, they're bound by laws and regulations, just as private citizens are. And so, like individuals, community groups will go through a "coming of age" when they will decide what their place in society is, what laws affect how they do business, and how they can use those laws to run most effectively.

Unfortunately, help sometimes seems a bit harder to come by than it did when we grew up and learned the laws we needed to follow (whether we liked it or not!). Eventually, a community organization will need to consider its legal position. And this brings up a myriad of difficult questions that make us wish all we had to deal with was a 1040-EZ form.

Some of the questions that most community groups will face are:

  • What different types of organizations exist? Just what type of organization are we? What kind of organization should we be?
  • We're nonprofit, right? What does that mean? Can we make a profit?
  • If we are a nonprofit group, are we tax-exempt? What does tax-exempt mean? Should we apply for it? How? Does it exempt the organization from federal, state, and local taxes?

In this section of the Tool Box, we'll walk you through the answers to these questions, and give you an idea of what it means to be nonprofit and tax-exempt. We'll explore the advantages and disadvantages of both, and talk about when it makes most sense for an organization to apply for such status. At the end, we'll give a brief overview of the nuts and bolts of the application processes.

Will you be able to fill out these applications on your own at the end of this section? Probably not. In fact, we strongly suggest you get professional help - either from a lawyer or an accountant who is well-versed in nonprofit and corporate law - as you decide what form your organization will take, and to help complete and file the papers. This section is not meant to take the place of an attorney or other legal counsel.

What we do hope this section will give you is an understanding of what's out there and what might be useful to your organization. We'd like to demystify some of the "legalese" that's so hard to understand, so you'll be able to make the best choices for your organization. If that makes sense to you, then let's begin.

What does it mean to be nonprofit and tax-exempt?

Are nonprofit and tax-exempt statuses the same?

No, but they are closely related. Nearly all organizations that are nonprofit wish to be tax-exempt as well, so the terms are often confused. Many charitable organizations, for example, are nonprofit organizations and are recognized by the federal government as being tax-exempt. But becoming nonprofit and becoming tax-exempt are different processes, done at different times (usually), and by different government agencies.

A first important distinction to make is that granting nonprofit status is done by the state, while applying for tax-exempt designation (such as 501(c)(3), the charitable tax-exemption) is granted by the federal government in the form of the IRS.

To apply for federal tax-exemption, you need to have been granted nonprofit status first. Further, not all nonprofits are eligible to be tax-exempt. Let's look at each term individually.

Nonprofit status

A nonprofit organization in its simplest variation, is any organization for which those who control or support it do not earn a profit. This doesn't mean that a nonprofit can't make a profit--quite the contrary is true. A nonprofit organization can produce goods and services, and it can earn a profit while doing so. It can even invest those profits (in the stock market, for example) in hopes of earning more money. However, all of the money made must go back into the organization - there is no "profit sharing" among members. Generally speaking, these organizations don't have any owners.

This is one reason that nonprofits are known more and more commonly as "not-for -profits." They may make a profit to help them stay in business, but making money is not their reason for being.

Individual states, and not the federal government, grant official nonprofit status. They may do so in slightly different ways, and give slightly different advantages for obtaining it. However, the federal government can recognize your nonprofit status. If you want to apply for tax-exemption, for example, you must be recognized as nonprofit by the federal government.

There are three types of nonprofit organizations that are recognized for this purpose by the federal government:

  • A corporation
  • An unincorporated organization
  • A trust

Becoming a corporation is perhaps the most common choice for community organizations. For incorporation, the organization must be structured according to specific state laws. These laws include having a "creating document" commonly known as the articles of incorporation, and rules of operation which are commonly known as bylaws. Usually, there is a board of directors and officers, and state laws (usually) limit the liability of members in varying degrees.

Often, incorporation is the best choice for a community organization. Part of this is simply a matter of perception, or of comfort, of the people with whom you work. People are familiar with corporations; they're used to working with them, and often perceive corporations as serious and dependable. Also, the limitations on personal liability mentioned above can be quite helpful.

Basically, the personal liability protection means that if someone feels the organization or one of its members has harmed him, only the organization may be sued, and not individual members if you have this protection. For example, if a potential employee feels she has not been hired because she is hearing-impaired, she can sue the organization as a whole, but not the person who interviewed her. Likewise, if the organization's director gets in an accident and hurts a passerby on the way to a coalition meeting, the organization, but not the director, may be sued.

It's important to note, however, that the limits of this liability do vary from state to state, and you should be aware of the laws that govern what you do. There may be circumstances in which directors or members of corporations may face personal liability. Some insurance companies offer additional insurance for directors and officers of nonprofit corporations.

An unincorporated organization is a group much like a corporation, and often has similar bylaws and purposes. Although the name seems to suggest otherwise, it is still a formal structure with an official structure. However, a constitution or other policies may take the place of the articles of incorporation, and there is no protection against personal liability. Additionally, much less reporting to the state occurs.

A trust generally has more narrow interests than a corporation or an unincorporated group. Many laws which govern trusts are created with charitable trusts (i.e, groups that give away money) in mind. Because of this, becoming a trust is rarely appropriate for a community group.

Going into depth on each of these types of organizations is beyond the scope of the section; for detailed information on each of them, you might speak with an attorney, or read B.R. Hopkins' Starting and managing a nonprofit organization: A legal guide.

And of course, you can certainly be a nonprofit organization in the loose sense of the word without ever filing papers, having a board, or any of those things. For example, a neighborhood group could be very effective without ever incorporating, or having a board, or even elected officers. It's still a nonprofit in practice, though, even if the law does not recognize it. We'll discuss the advantages and disadvantages of becoming officially recognized later in the section.

Federal tax-exempt status

Organizations that are exempt from federal taxes are described sections in the United States Tax Code. The best known type of tax-exemption is 501(c)(3), also known as the "charitable tax exemption." This designation allows exemption from federal corporate and income taxes for most types of revenue. Also, organizations designated as 501(c)(3) are able to solicit tax deductible contributions. 501(c)(3) is most appropriate for many community organizations, and (except where indicated otherwise) it will be used interchangeably with the term tax-exempt for the remainder of this section.

However, before we move on, we should mention that there are a total of 26 exemptions under the tax code for different purposes, and some community organizations might find one of them more appropriate. For example, a group that is involved in heavy lobbying or political advocacy work would be unable to apply for 501(c)(3) status, as it isn't allowed under that statute. So a group heavily involved in social welfare that wants to lobby extensively for political candidates, for example, might find 501(c)(4) status (which deals uniquely with social welfare organizations) more appropriate for their purposes.

So before deciding to become 501(c)(3), it's a good idea to sit down and study other possibilities with an expert. Together, you can decide on the type of exemption that best meets your needs. That way, you won't be trying to push a square peg into a round hole. More information on the different tax exemptions, as well as other technical details not discussed in this section, may be found on the IRS website.

Generally, an organization becomes tax-exempt by applying for the status. This is a fairly long process. The application form (Form 1023 for 501(c)(3) organizations; Form 1024 for others) is approximately 30 pages, and the IRS suggests that it (1023) will take about eight hours to complete--and that's after you have done record keeping (on expenses, revenue, and the like) and learned the law. It usually takes several months to be granted status.

However, several weeks after you complete and mail the forms, the IRS will send you a letter saying your status is "pending." This letter is usually enough proof for funders and others who might require proof of your exempt status.

When status is granted, the IRS will send a "letter of determination" that your organization can then use to prove its tax-exempt status on a more permanent basis. You might need the letters to show to foundations when applying for a grant, for example, or when you are applying for state tax-exemption.

Additionally, however, there are two ways of having tax-exempt status without filing: automatic recognition and a fiscal conduit.

Automatic recognition

Some organizations are automatically recognized as having 501(c)(3) status; they don't need to file. These groups include:

  • Subordinate organizations that are evaluated by parent groups, or are covered by a group exemption
  • Churches, parts of churches, or associations of churches
  • Organizations that are not private foundations and normally have gross receipts of not more than $5,000. For example, a group of citizens trying to convince the city council to create bike lanes on major streets might fall into this category. This recognition is particularly helpful for small grassroots groups who don't have the experience, time, and money necessary to file for exemption.

Even though these groups are automatically tax-exempt, they may choose to file anyway, in order to have the official letter of determination on file. This often makes it easier to solicit contributions and ask for exemptions from state taxes.

Fiscal conduit

A fiscal conduit is an organization that is already incorporated and tax-exempt that administers funds and performs other administrative tasks for your group. Also called a "lead agency," they can be invaluable in helping out with the organization of your group, reimbursing contractors, and sharing space. Local United Ways and public health departments are two examples of groups that often serve as fiscal conduits.

A fiscal conduit may be what you need at the very beginning. The lead agency can do all the paperwork for you, and provide other kinds of less tangible support that can really help you, at least at the start. Why not use that support if it's available?

State tax-exemption

State exemptions can include many different things, including exemptions from sales tax, income tax, and property tax. Again, these laws vary, so check with the Secretary of State's office for rules for your state. In some states, however, the requirements are the same as those of the federal government, and showing proof of 501(c)(3) status is enough to exempt you from many state taxes.

What are the advantages of nonprofit and tax-exempt status?

There are quite a few advantages to having the official status.

For nonprofit status:

  • If you want to assume fiduciary responsibility for all of the funds and to contract directly with the state, you will need to be an incorporated nonprofit organization
  • As an incorporated nonprofit organization, you'll be able to take advantage of reduced postal rates for many purposes
  • And, as an officially recognized nonprofit, you can apply for federal tax-exemption, which leads to many more advantages

For federal tax-exempt status:

  • As we mentioned above, you are freed from many taxes, and potential donors can make tax-deductible contributions. The latter is a powerful advantage for many groups who survive mainly on contributions and grants.
  • You can apply for grant funds directly. Almost all foundation or government grants require evidence of federal tax-exempt (501(c)(3)) status. If you don't have it, you will need some kind of fiscal conduit in order for your grant application to be considered.
  • Your group now becomes more independent, free (or at least freer) from the potential control of fiscal agents or others who have helped you before, even if they have been generally sympathetic.
  • The independence you gain can be a psychological boost to your organization

What are the disadvantages of nonprofit and tax-exempt status?

Although applying for official nonprofit and tax-exempt statuses can be very helpful, there can also be some disadvantages to doing so.

  • Incorporation creates another level of complexity, responsibility, and regulation that a volunteer-based organization may not be prepared to handle. For example, your organizations must send an annual tax-return to the IRS.
  • Filing for incorporation and tax-exemption takes time and money. For example, at this writing (in 1998) the fee for filing for federal exemption is $500 for most groups, and $150 in a limited number of cases. Fees for tax advisors (legal and accounting) can also be substantial.
  • For a group in the very beginning stages, incorporation and tax-exemption may not be necessary. It's often best to focus on doing the work, and developing a track record of success. Incorporation and related issues can become a distraction; they can be taken up later.
  • Incorporation and federal tax-exemption may limit certain lobbying and advocacy activities. For example, you cannot (as an organization) support candidates for public office.
  • The community may perceive creating another nonprofit organization as an additional level of bureaucracy.
  • Tax-exempt organizations are taxable, to the extent that they participate in activities unrelated to the performance of tax-exempt functions. While this isn't exactly a disadvantage, it is something you should take into consideration.

When should you consider applying for nonprofit and tax-exempt status?

After taking into account all of the advantages and disadvantages of applying for nonprofit and tax-exempt status, you might decide that they are the right steps for your organization to take. But is now the right time to take the plunge?

Maybe so, if:

  • Your group has proven its worth through specific community accomplishments
  • Your group, and in particular its leaders, are committed to continuing its activities and staying in existence for the foreseeable future
  • Your group plans to be applying for grants on a regular basis, or you will be selling a significant amount of goods/services
  • No suitable fiscal agent or fiscal conduit is locally available

When you might not want to apply for nonprofit and tax-exempt status

On the other hand, you might decide that the time isn't right to apply when:

  • You are not sure if the organization will continue
  • The group does not need outside grants/money for successful operation
  • A fiscal agent or fiscal conduit, whose views are similar to your own, is willing to handle any grant applications or other fiscal affairs

Any of these conditions might be enough, individually, to convince you to consider holding off for a while. However, organizations will want to look over all of the details of their own situation, and decide what makes most sense for them.

One more point to take into consideration: if you apply for exemption within the first 15 months of being created, your tax-exempt status can be applied retroactively to the founding date of your organization. The federal government also gives an automatic 12-month extension on this regulation. That means functionally, you must apply within 27 months of being created to avoid taxes for the start-up period of your organization. For groups who know from the outset that they want to be around for the long haul, then, it might make sense to apply relatively early in the life of the organization.

How do you apply for nonprofit status?

Procedures for becoming an official nonprofit organization will vary greatly from state to state, and so we won't spend too much time talking about it here.

But a general overview of the process might look like this:

  • Hire legal counsel to help make the decisions and guide you through the process
  • Decide if it makes sense for your organization to apply for such status now
  • Decide what type of nonprofit organization it makes sense for you to be (a corporation, an unincorporated organization, or a trust)
  • Decide the state in which you want to apply for nonprofit status - usually, this will be your home state; but some states have laws that are "friendlier" to nonprofits or to particular causes
  • Apply for nonprofit status in accordance with the regulations for your state and type of organization. Contact the Secretary of State's office to learn more about those procedures. If you plan to later apply for tax-exempt status as well, it's important to pay particular importance to the wording and content of items such as your articles of incorporation, as some of the federal government's regulations are very specific.
  • Be sure you understand the state's ongoing requirements for reporting and renewal

How do you apply for federal tax-exempt status?

The steps for applying for federal tax-exempt status are quite similar to applying for nonprofit status. There are, however, some important differences.

Briefly, the steps involved are:

  • Hire legal counsel to help make the decisions and guide you through the process
  • Determine if you are eligible for tax-exempt status, and if your organization is automatically exempt
  • Decide if it makes sense for your organization to apply for such status now
  • If you are not already a nonprofit organization (as designated by the state), you will need to become so
  • Decide the tax-exemption (e.g., 501(c)(3), 501(c)(4)) for which your organization is eligible.
  • Apply for exemption from the IRS
  • Be sure you understand the ongoing requirements for reporting and renewal

A last word on getting help

Throughout this section, we have suggested getting help from an accountant or a lawyer when you are going through these processes. But those fees add up; how can a relatively poor organization afford this type of counsel?

Our advice is to look for professionals who will either donate their time or do the work at a reduced cost. You might find this help:

  • By asking around. Most organizations have someone involved who is either a professional himself, or knows someone who is. Don't be shy about asking for help. Remember, you're not asking for yourself--you are asking on behalf of a cause you believe in.
  • The Legal Aid organization in your town should have, at the very least, a list of lawyers in town willing to do pro bono work, and the American Bar Association might as well.
  • You might also look and see who advertises in publications related to what you are doing. For example, if you are a member of the local AIDS project, you might want to see if any lawyers or CPAs advertise in the local gay press. Some of the people advertising may well be willing to volunteer or have a reduced fee for a cause they believe in.

When looking for help, you might want to try going through all of the channels listed above, and it may take some time before you find someone competent to help you out. Sheer persistence, however, often makes the difference - don't give up the first time someone tells you no.

In Summary

Understanding the legal system that surrounds the nonprofit world is certainly not an easy thing to do. In this section, we have left out many of the finer points of the law, to give you a general understanding you can use as you talk with legal council, or read through some of the more detailed literature on the system.

As you get more in depth into your study of the laws surrounding nonprofit organizations, it's easy to get lost in the details. But remember, the system was set up to help nonprofits, not hinder them. When you have a solid understanding of the system, your organization can use it to its advantage. By doing so, you've made an important step along the path of becoming a successful, self-sustaining organization.

Print Resources

Colombo, J.D., and Hall, M.A. (1995). The charitable tax-exemption. Boulder, CO: Westview Press.

Galvin, W. R. (1996). Organizing a non-profit corporation. [Brochure]. Boston, MA: Commonwealth of Massachusetts.

Hopkins, B.R. (1989). Starting and managing a nonprofit organization. New York, NY: John Wiley & Sons.

John Snow, Inc. Creating partnerships that work: A developmental manual for Ryan White title II HIV Health Care Consortia. Boston.

Overton, G.W. (Ed.) (1993). Guidebook for directors of nonprofit corporations. Chicago, IL: American Bar Association, Section of Business Law.

Online Resources

The IRS's How to apply to be tax exempt page provides all the information you would need, as well as forms to download.

The American Bar Association Network has links to inexpensive legal help in your area.

The Tides Center and The Tides Foundation is dedicated to the promotion of non-profit organizations.

U.S. Postal Service Publication 417 provides information on determining if you qualify for reduced postal rates (and if so, how to get them).