Section 4. Understanding Nonprofit Status and Tax Exemption

• 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 might you decide not to apply yet?

• How do you establish a nonprofit organization?

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

• A last word on getting help

Community organizations operate within legal and regulatory systems. As an organization develops, it may need to decide what legal structure best supports its mission, how responsibilities and liabilities will be managed, whether federal tax-exempt recognition is appropriate, and what ongoing governance, tax, reporting, and fundraising requirements will apply.

Common questions include:

• What legal structures are available, and which one fits our organization?
• What does it mean to operate as a nonprofit organization?
• Can a nonprofit organization generate revenue or end the year with a financial surplus?
• Is nonprofit status the same as tax-exempt status?
• Should we seek federal recognition under section 501(c)(3) or another section of the Internal Revenue Code?
• What federal, state, and local tax requirements will still apply?
• Would forming a separate organization make sense, or could fiscal sponsorship or another arrangement better support the work?

This section provides a general overview of nonprofit organizational status and federal tax-exempt recognition in the United States. It discusses some advantages and responsibilities of establishing a separate nonprofit organization, factors to consider when deciding whether to apply, and the basic steps involved.

Laws, tax rules, filing requirements, and fees change over time and vary by jurisdiction and type of organization. This section does not substitute for legal, tax, or accounting advice. Use current information from the IRS and appropriate state and local agencies, and consult qualified professionals when necessary.

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

Are nonprofit and tax-exempt statuses the same?

No. They are related, but they refer to different legal concepts.

An organization is generally formed under the law of a state, tribal government, or other applicable jurisdiction. Federal tax-exempt recognition is governed by the Internal Revenue Code and administered by the Internal Revenue Service.

Creating a nonprofit organization under state law does not automatically make the organization exempt from federal income tax, and federal tax-exempt recognition does not automatically provide exemption from every state or local tax.

Nonprofit organizational status

A nonprofit organization exists to pursue a purpose rather than to distribute profits to owners or shareholders. A nonprofit may charge fees, sell products and services, receive investment income, and generate more revenue than expenses in a particular year.

What distinguishes a nonprofit is not that it must avoid generating a financial surplus. Rather, its net earnings and assets generally must be used in ways consistent with its organizational purposes and applicable law instead of being distributed for the private benefit of owners.

Organizations may take several legal forms. Depending on applicable state law and federal tax requirements, these may include:

• Nonprofit corporations
• Unincorporated associations
• Trusts
• In some circumstances, limited liability companies structured to satisfy applicable tax-exemption requirements

The best form depends on the organization's activities, governance, liability concerns, funding plans, tax classification, and applicable state law.

Incorporation

Incorporation is a common choice for community organizations that expect to operate over time, enter contracts, employ staff, receive significant funding, own property, or take responsibility for substantial programs.

State law generally governs how a nonprofit corporation is created and operated. Requirements commonly include filing articles of incorporation or another organizing document and establishing appropriate governance procedures, such as bylaws, directors, and officers.

Incorporation may provide some separation between the organization's legal obligations and the personal assets of directors, officers, members, or other individuals. However, incorporation does not eliminate every possibility of personal liability.

Individuals may still face personal responsibility in circumstances involving their own wrongful conduct, certain employment or tax obligations, breaches of fiduciary duty, guarantees, or other matters governed by applicable law. Appropriate insurance, including directors and officers liability coverage when needed, may provide additional protection.

Unincorporated associations and trusts

An unincorporated association may provide a formal structure without creating a nonprofit corporation. State law determines how such organizations are created and what legal protections and obligations apply.

A trust may also qualify for federal tax-exempt recognition when properly organized and operated, although a trust structure may be more appropriate for some purposes than others.

Organizations should obtain legal advice when choosing among these structures because questions of governance, ownership of property, contracting authority, liability, dissolution, and tax treatment can differ substantially.

Informal community groups

Not every community effort needs to create a separate legal organization. Neighborhood groups, coalitions, mutual-aid efforts, advocacy campaigns, and other initiatives may sometimes operate effectively without incorporating.

However, an informal group may eventually need a more formal structure if it wants to employ staff, enter contracts, own significant assets, receive particular grants, manage substantial funds, or obtain federal tax-exempt recognition.

Federal tax-exempt status

The Internal Revenue Code includes several classifications of tax-exempt organizations. One of the most common for charitable community organizations is section 501(c)(3).

Organizations recognized under section 501(c)(3) must be organized and operated for qualifying exempt purposes, such as charitable, educational, religious, scientific, or other purposes recognized by federal law.

Recognition under section 501(c)(3) generally exempts qualifying income from federal income tax, although some activities may still create tax obligations. Organizations may also be subject to employment taxes, unrelated business income tax, excise taxes, and other federal, state, or local taxes depending on their activities.

Contributions to qualifying 501(c)(3) organizations generally may be deductible as charitable contributions by donors, subject to applicable federal tax rules.

Advocacy, lobbying, and political campaign activity

Advocacy and lobbying are not the same as political campaign intervention.

A 501(c)(3) organization may engage in some lobbying related to legislation. However, lobbying cannot exceed the limits applicable to the organization. Eligible public charities may also choose to measure lobbying expenditures under the section 501(h) expenditure test.

A 501(c)(3) organization is prohibited from participating or intervening in a political campaign on behalf of, or in opposition to, a candidate for elective public office.

Nonpartisan voter education, public policy education, voter registration, candidate forums, and related civic-engagement activities may be permitted when conducted in accordance with applicable rules.

Other tax-exempt classifications have different rules. For example, a qualifying 501(c)(4) social-welfare organization may engage substantially in lobbying that furthers its exempt purposes and may engage in some political campaign activity, but campaign activity cannot become its primary activity. Contributions to most 501(c)(4) organizations generally are not deductible as charitable contributions.

Organizations expecting substantial lobbying, electoral, or other advocacy activity should obtain legal or tax guidance before deciding which organizational and tax structure best fits their work.

Applying for federal recognition

Most organizations seeking recognition under section 501(c)(3) apply using Form 1023 or, when eligible, the streamlined Form 1023-EZ.

Organizations seeking recognition under section 501(c)(4) use Form 1024-A. Many organizations seeking recognition under other sections of 501(c) use Form 1024.

These exemption applications are submitted electronically through Pay.gov, and current user fees apply.

When the IRS approves an application, it issues a determination letter describing the organization's recognized tax-exempt status and other relevant information.

Organizations that may not be required to file Form 1023

Some organizations that otherwise satisfy section 501(c)(3) requirements are excepted from the requirement to file Form 1023 or Form 1023-EZ for recognition of exemption.

Examples include:

• Churches, certain church-related organizations, and conventions or associations of churches
• Certain organizations, other than private foundations, whose gross receipts are normally not more than the amount established by federal law
• Qualifying subordinate organizations covered under an appropriate group exemption arrangement

Some organizations that are not required to apply may choose to do so in order to obtain an IRS determination letter and appear in IRS records of recognized tax-exempt organizations.

Fiscal sponsorship

Creating a new tax-exempt organization is not always necessary. A project may instead operate under a formal fiscal sponsorship arrangement with an existing nonprofit organization whose mission is compatible with the proposed work.

Under fiscal sponsorship, the sponsor generally assumes defined legal and financial responsibility for charitable funds and activities associated with the sponsored project. Contributions intended for the project are generally made to the fiscal sponsor, which must maintain appropriate control and oversight of the charitable funds.

Fiscal sponsorship arrangements vary considerably. A written agreement should clarify responsibilities such as:

• Financial oversight and accounting
• Ownership and control of funds
• Grant and donor administration
• Employment or contractor relationships
• Insurance and risk management
• Intellectual property
• Administrative fees
• Decision-making authority
• Reporting requirements
• Procedures for ending or changing the sponsorship relationship

Fiscal sponsorship can be useful for new, temporary, experimental, or relatively small projects and for groups that want to focus on the work rather than immediately creating a separate organization. It also carries responsibilities and tradeoffs, so both the project and sponsor should understand the arrangement clearly.

State and local tax exemptions

Federal tax-exempt recognition does not automatically provide exemption from all state and local taxes.

Depending on the jurisdiction and the organization's activities, separate exemptions or registrations may be required for state income or franchise tax, sales and use tax, property tax, charitable solicitation, and other matters.

Requirements vary significantly. Consult the appropriate state revenue, taxation, charity-registration, property-tax, and corporate-filing authorities rather than assuming that one state office handles every issue.

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

The advantages depend on the organization's structure, activities, and tax classification.

Possible advantages of forming a nonprofit corporation include:

• Establishing a separate legal entity that can enter contracts, employ staff, receive funding, and hold assets
• Providing continuity beyond the participation of particular founders or members
• Establishing formal governance and accountability structures
• Limiting personal liability in many circumstances, subject to applicable law
• Making it easier to establish banking, insurance, contracting, and other organizational relationships
• Creating an eligible organizational structure from which federal tax-exempt recognition may be pursued

Possible advantages of 501(c)(3) recognition include:

• Federal income-tax exemption for qualifying activities and income
• Eligibility to receive tax-deductible charitable contributions, subject to applicable law
• Eligibility for grants and other funding opportunities that require or prefer recognized charitable status
• Greater ability to receive and manage charitable funds directly rather than through a fiscal sponsor
• Eligibility for certain state, local, postal, or other benefits when applicable
• An established legal and governance structure that may strengthen continuity and accountability

These advantages should not be overstated. Not every grant requires 501(c)(3) status, and governmental entities, tribal entities, fiscally sponsored projects, schools, or other eligible organizations may also qualify for particular funding opportunities.

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

Creating and maintaining a nonprofit and tax-exempt organization also involves responsibilities and costs.

• Ongoing governance and compliance. Organizations may need to maintain a governing board, follow bylaws and state corporate requirements, keep appropriate records, make required disclosures, and file federal, state, and local reports.
• Startup and continuing costs. Incorporation, federal exemption applications, professional assistance, registrations, insurance, accounting, annual reports, fundraising compliance, and other responsibilities may involve fees and staff time.
• Federal annual filing requirements. Many tax-exempt organizations must file an applicable Form 990-series return or notice. Requirements vary according to classification, size, and other circumstances.
• Restrictions on private benefit. Organizational earnings and assets cannot be operated for the improper benefit of insiders or other private interests.
• Rules governing lobbying and political activity. A 501(c)(3) may conduct limited lobbying but may not intervene in candidate campaigns.
• Possible tax on unrelated business activity. Tax-exempt organizations may owe federal income tax on certain income from regularly carried-on businesses that are not substantially related to their exempt purposes, subject to exclusions and exceptions.
• Public disclosure. Certain exemption applications and annual federal information returns are generally available to the public.
• Less flexibility than an informal project. Creating a separate organization can add governance, administrative, financial, and legal obligations that may not be necessary for a small or short-term initiative.

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

Establishing a separate nonprofit organization may make sense when the structure supports the work better than available alternatives.

Consider factors such as:

• The organization has a clear charitable or community-focused mission and expects to operate for the foreseeable future
• A separate legal entity would help the organization employ staff, enter contracts, own assets, obtain insurance, or manage substantial funds
• The organization expects to seek grants or charitable contributions for which recognized tax-exempt status would be useful or required
• There is a committed governing body capable of fulfilling legal, financial, and fiduciary responsibilities
• The organization has or can develop the administrative capacity necessary for accounting, tax filings, governance, fundraising compliance, insurance, and other ongoing requirements
• A separate organization fills a meaningful need rather than unnecessarily duplicating the work of an existing organization
• Available fiscal sponsorship, partnership, or coalition arrangements would not meet the project's long-term needs as effectively

An organization does not need to establish a long record of accomplishments before considering incorporation. What matters more is whether creating a separate legal entity is appropriate to the mission, planned activities, governance, resources, risks, and expected duration of the work.

When might you decide not to apply yet?

Forming a separate nonprofit organization may not be the best option when:

• The project is temporary, experimental, or its long-term future is uncertain
• The work can be carried out effectively without creating another legal entity
• An existing organization could appropriately house the program or initiative
• A qualified fiscal sponsor can provide the necessary financial and administrative infrastructure
• The group does not yet have people willing and able to carry out governance and compliance responsibilities
• Available resources would be better directed toward the work itself rather than maintaining a separate entity
• A coalition, partnership, association, or other structure better fits the purpose

Consider both the advantages of independence and the costs of creating another organization. In some communities, strengthening an existing organization or sharing infrastructure may be more effective than creating a new nonprofit.

Timing of a 501(c)(3) application

Timing can affect the effective date of federal exemption.

In general, when an organization files a qualifying Form 1023 or Form 1023-EZ within the period established by IRS rules after legal formation and the application is approved, recognition may be effective from the organization's formation date. Filing later may result in a later effective date unless the organization qualifies for relief under applicable rules.

Because these timing rules have technical requirements, consult the current Form 1023 or Form 1023-EZ instructions rather than relying on an older summary.

How do you establish a nonprofit organization?

Procedures vary by state and organizational form. A general process may include:

• Clarify the organization's mission, activities, governance needs, and long-term plans
• Determine whether forming a separate legal entity is preferable to fiscal sponsorship, partnership, or another arrangement
• Obtain legal and tax advice when appropriate
• Select an organizational form permitted under applicable law
• Choose the jurisdiction in which the organization should be formed based on where it operates and its actual legal and organizational circumstances
• Select and check the availability of the organization's legal name
• Prepare and file the required organizing documents
• Include provisions needed for the intended federal tax classification, such as appropriate charitable-purpose and dissolution provisions when seeking 501(c)(3) recognition
• Adopt bylaws or other governance policies
• Appoint or elect the governing board and officers as required
• Obtain an Employer Identification Number when needed
• Establish banking, accounting, insurance, recordkeeping, and internal-control systems
• Understand ongoing corporate, charitable-solicitation, employment, tax, and reporting requirements

State filing agencies and requirements differ, so use current information from the jurisdiction in which the organization will be formed.

How do you apply for federal tax-exempt status?

The application depends on the section of the Internal Revenue Code under which the organization is seeking recognition.

For many charitable organizations seeking 501(c)(3) recognition:

• Confirm that the organization's legal form and organizing documents satisfy applicable requirements
• Obtain an Employer Identification Number if needed
• Determine whether the organization is required to apply or qualifies for an exception from the application requirement
• Determine whether the organization is eligible to use Form 1023-EZ or must use Form 1023
• Prepare required information about the organization's purposes, activities, governance, finances, compensation, fundraising, and other matters
• Submit the application electronically through Pay.gov
• Pay the current IRS user fee
• Respond promptly if the IRS requests additional information
• Retain the determination letter and application records
• Understand ongoing federal, state, and local compliance requirements

Organizations seeking other classifications should use the current IRS guidance for the appropriate application. For example, Form 1024-A applies to organizations seeking recognition under section 501(c)(4), while Form 1024 applies to many other organizations seeking recognition under section 501(a).

Receiving recognition is not the end of compliance. Tax-exempt organizations must continue to operate consistently with the requirements of their exemption and meet applicable filing, disclosure, governance, employment, fundraising, and tax obligations.

A last word on getting help

Nonprofit formation and tax-exemption questions can involve corporate law, federal tax law, state charitable-solicitation requirements, employment law, accounting, governance, insurance, intellectual property, and other areas. Professional help can therefore be valuable.

Possible sources of assistance include:

• Attorneys and accountants with nonprofit experience
• Nonprofit legal clinics and law-school clinics
• State and local bar-association referral or pro bono programs
• Community foundations and nonprofit-support organizations
• Professional associations for accountants and attorneys
• Fiscal sponsors and nonprofit capacity-building organizations
• Qualified professionals willing to provide reduced-fee or pro bono assistance

When choosing professional help, look for experience relevant to nonprofit organizations and to the specific legal or tax issues involved. Free assistance can be valuable, but affordability should not be the only consideration; inaccurate legal or tax advice can create substantial problems later.

In Summary

Nonprofit organizational status and federal tax-exempt recognition are related but distinct. State or other applicable law generally governs formation of the legal organization, while federal tax exemption is governed by the Internal Revenue Code and administered by the IRS.

Creating a separate nonprofit and seeking tax-exempt recognition can provide important benefits, including continuity, the ability to manage charitable resources directly, eligibility for certain grants, and the ability of qualifying organizations to receive tax-deductible charitable contributions. These benefits come with ongoing responsibilities involving governance, accounting, reporting, public disclosure, fundraising, employment, and compliance.

A separate nonprofit organization is not always necessary. Fiscal sponsorship, partnerships, coalitions, or operation within an existing organization may sometimes support community work more effectively and with less administrative burden.

Before choosing a structure, consider the organization's mission, activities, expected duration, governance capacity, funding strategy, advocacy plans, liability risks, community relationships, and administrative resources. Use current federal and state guidance and obtain qualified legal, accounting, or tax assistance when needed.