What is a tax-exempt nonprofit?
The “simple” answer is it is an entity that doesn’t have to pay taxes. While technically true, there’s a little bit more to it …
A tax-exempt nonprofit corporation is an entity formed to carry out a specific purpose which allows it to qualify for tax exemption. The most common types of exempt missions are charitable, educational, promotion of health or lessening the burden of government.
Here are some of the main differences between a tax-exempt nonprofit corporation and other corporations:
- A nonprofit corporation is not owned. Therefore, it cannot be sold. Rather, if a tax-exempt nonprofit corporation is dissolved the assets of the corporation must be distributed to another tax-exempt nonprofit.
- A nonprofit corporation with tax exempt status under 501(c)(3) is exempt from paying income taxes. However, it is not necessarily exempt from all taxes. It may still be subject to sales tax, property tax, payroll tax, unrelated business income tax, and excise taxes unless a specific exemption exists. Most exemptions depend on specific state rules and often are impacted by the type of entity and the activities of the entity.
- Once a nonprofit corporation has obtained tax-exempt status under IRC Section 501(c)(3) it may accept tax-deductible donations. Donation receipts should identify the tax-exempt nonprofit (ex. letterhead), the date of the gift and a description of what was received. For cash donations, the amount received should be listed. For donations of goods, a descriptor of the item should be listed. The organization is not required to include the value of the donated good, this is the donor’s responsibility. In addition, the donation receipt should indicate whether the donor received anything from the organization in exchange for the donation. If not, a phrase such as “no goods or services where given in exchange for the donation” should be included.
How do you create a tax-exempt nonprofit?
The steps to set up an entity are fairly straightforward. However, you will likely need the assistance of legal and tax professionals to help you navigate through them.
Step 1: File the Articles of Incorporation with the State
Articles of Incorporation are typically filed in the state where the organization will be operated. You can do it alone but may need the assistance of legal counsel. There are a tax related clauses which must be in the Articles of Incorporation in order for the entity to gain tax-exempt status:
- The activities of the organization must be limited to exempt purposes and the Articles must not allow it to engage more than insubstantially in activities that are not in furtherance of this purpose. In determining the exempt purpose, you should consider what you are hoping to accomplish with the nonprofit? The IRS provides the following as an example of an acceptable purpose clause:
The organization is organized exclusively for charitable purposes under section 501(c)(3) of the Internal Revenue Code, or corresponding section of any future federal tax code.
You can elaborate on the specifics of the charitable purpose, but make sure that the details do not expand beyond the tax exempt requirements.
- Your articles must limit the conduct of lobbying activities to an insubstantial part of your activities and specifically prohibit the organization from conducting political activities.
- As mentioned earlier, a nonprofit corporation does not have owners. As such, the Articles must include a dissolution clause dedicating the assets upon dissolution to another exempt organization. The IRS example is as follows:
Upon the dissolution of this organization, assets shall be distributed for one or more exempt purposes within the meaning of section 501(c)(3) of the Internal Revenue Code, or corresponding section of any future federal tax code, or shall be distributed to the federal government, or to a state or local government, for a public purpose.
Step 2: Obtain an Employer Identification Number (EIN)
What is an EIN and how do you get it?
An EIN is the corporation’s unique identifying number with the IRS. You can obtain an EIN through an online application process (make sure you select Tax Exempt/Nonprofit as your entity type).
Side Note: Once you have your EIN, it’s a good idea to open a business banking account; it is very important not to mix personal expenses with business expenses.
Step 3: Request tax-exempt status with the IRS
If you wish to be a 501(c)(3), you MUST request an exemption from the IRS. If you do not apply for tax exempt status, your corporation will be treated as a taxable corporation, subject to corporate income taxation. You must have your state approved Articles of Incorporation and EIN prior to filing the request.
There are two options for applying for tax exempt status, based on the estimated gross receipts you expect to generate on an annual basis.
- Form 1023-EZ: This form is available if your gross receipts are expected to be less than $50,000 per year for the first three years of operations. This form can be completed online.
- Form 1023: If your gross receipts are expected to be more than $50,000 per year, the longer form must be completed. The form is available online, however it cannot be submitted electronically.
If you need assistance with filing your forms, a tax professional is a good resource.
Step 4: Operate for Exempt Purposes
You should receive notice from the IRS acknowledging your application within two to six weeks. Assuming the IRS approves your application, you will receive a determination letter confirming your exemption within three to six months of filing. Once you receive your confirmation, you can operate the organization for the exempt purpose as stated in your Articles of Incorporation.
If you expand your operations beyond the initial exempt purpose for which your exemption was granted, the expansion may result in unrelated business income (UBI) that results in a tax liability or may result in potential loss of tax exempt status.
Step 5: Complete your annual filings
There are filing requirements at both the federal and state level.
- Federal Filings: You will be required to submit Form 990-N, 990-EZ or 990 on an annual basis with the IRS. The return is due 4 ½ months after your fiscal year end. The amount of information and the complexity of the filing varies with each form. Use the chart below to help determine what form you need to file.
|Gross Receipts||<$50,000||<$200,000||No limit|
|Assets||No limit||<$500,000||No limit|
Note: Annual filing are required even if you have not yet received your determination letter.
- State Filings: The filing requirements vary by state however here are a few examples of potential requirements:
- Secretary of State Annual Report- Confirms ongoing existence of the organization.
- Charitable Report-Typically filed due to holding charitable assets in a state or to solicit contributions in the state
- State Income Tax Return–Filed to report unrelated business income
We would recommend enlisting legal and/or tax guidance throughout the process if you have any questions or hesitations. These professionals want to see your mission succeed from the start. If you need help finding the resources, we can help!