If you’ve already formed your nonprofit organization, congratulations! You’ve taken the first step in creating a charity or tax exempt organization.
However, just because you formed a nonprofit organization doesn’t mean that you will automatically be tax exempt. The IRS has specific requirements that must be followed before it will grant tax exempt status to a charity or other qualified organization. Section 501(c)(3) of the Internal Revenue Code gives many types of organizations that may qualify to be tax exempt. Because many tax exempt organizations fall under this rule, this is why many people refer to tax exempt organizations as 501(c)(3) organizations. In order to be tax exempt under Section 501(c)(3), an organization must be organized and operated exclusively for exempt purposes set forth in Section 501(c)(3), and none of the company’s earnings may inure to the benefit of any private individual. In addition, a tax exempt organization can’t attempt to influence legislation as a substantial part of its activities nor can it participate in any campaign activity for or against political candidates. Let’s examine each of these requirements individually:
Nonprofit / Charity Organizational Test
First, you must show that your organization is properly formed to be tax exempt organization. In order to pass this organizational test, an organization must be a corporation or unincorporated association, community chest, fund or foundation. A charitable trust is either a fund or foundation and may qualify, however an individual cannot qualify. The IRS will look at the entity’s organizing documents to check if the required language is included. For a nonprofit corporation, the organizing document is called the Articles of Incorporation. The organizing documents of the entity must limit the entity’s purposes to those set forth in Section 501(c)(3) and must not permit activities that are not in furtherance of those purposes. The IRS gives the following example of this specific language on its website:
Said corporation is organized exclusively for charitable, religious, educational, and scientific purposes, including, for such purposes, the making of distributions to organizations that qualify as exempt organizations under section 501(c)(3) of the Internal Revenue Code, or the corresponding section of any future federal tax code.
You can find more examples of this required language in IRS Publication 557, Chapter 3.
In addition, the assets of the organization must be permanently dedicated to an exempt purpose. This means that if the organization stops operating, any of the organization’s remaining assets must be distributed for an exempt purpose. This must be shown by including a provision in the organizational document that states that in the event of dissolution the assets will be distributed for an exempt purpose. The IRS gives the following example on its website:
Upon the dissolution of the corporation, assets shall be distributed for one or more exempt purposes within the meaning of section 501(c)(3) of the Internal Revenue Code, or the 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. Any such assets not so disposed of shall be disposed of by a Court of Competent Jurisdiction of the county in which the principal office of the corporation is then located, exclusively for such purposes or to such organization or organizations, as said Court shall determine, which are organized and operated exclusively for such purposes.
Nonprofit Operational Test – Operated Exclusively for Exempt Purposes
In order to qualify as an exempt organization, the organization must also show that it is operated exclusively for one or more exempt purposes. When people think of an exempt organization, they usually think of a charity. However, the IRS will classify a number of different types of organizations as long as they are operated exclusively for one or more exempt purposes if the organization primarily engages in activities that further and/or accomplish exempt purposes listed in Section 501(c)(3). If more than an insubstantial part of an organization’s activities do not further one or more exempt purposes, the organization will not be regarded as operated exclusively for exempt purposes and thus unqualified to obtain tax exempt status. The exempt purposes set forth in Section 501(c)(3) are:
Charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals. The term charitable is used in its generally accepted legal sense and includes relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.
Regardless of which exempt purpose(s) an organization may serve, tax exempt organizations are often referred to as charitable organizations.
Important point: When you think about which exempt purpose(s) your organization will further and/or accomplish, consider the class of people the organization will benefit. This class of people served is called the charitable class. A charity or organization that wishes to be tax exempt must be set up for the benefit of an indefinite class of individuals, not for specific persons. Thus, an organization set up to benefit John Smith is not a charitable organization, even if the organization can show that John Smith is deserving of the services provided by the organization. In this example, assume your organization is set up to generally help impoverished individuals in a certain community. In that case, the organization may select John Smith as a beneficiary if in fact he is an impoverished individual in that particular community.
As you can probably tell from the charitable class requirement, a tax exempt organization may not be organized or operated to benefit private interests. This includes the company’s officers and directors, their families, shareholders of the organization (if any), or other people being controlled directly or indirectly by such persons. No part of the net earnings of a tax exempt organization may inure to the benefit of any individual or private shareholder that has a personal interest in the activities of the organization. The IRS will especially scrutinize any benefit received by the company’s officers, directors, families, etc. The company’s organizing documents should contain language stating that none of the company’s net earnings will inure to the benefit of any individual or private shareholder. The IRS gives the following example on its website:
No part of the net earnings of the corporation shall inure to the benefit of, or be distributable to its members, trustees, officers, or other private persons, except that the corporation shall be authorized and empowered to pay reasonable compensation for services rendered and to make payments and distributions in furtherance of the purposes set forth in Article Third hereof. No substantial part of the activities of the corporation shall be the carrying on of propaganda, or otherwise attempting to influence legislation, and the corporation shall not participate in, or intervene in (including the publishing or distribution of statements) any political campaign on behalf of or in opposition to any candidate for public office. Notwithstanding any other provision of these articles, the corporation shall not carry on any other activities not permitted to be carried on (a) by a corporation exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code, or the corresponding section of any future federal tax code, or (b) by a corporation, contributions to which are deductible under section 170(c)(2) of the Internal Revenue Code, or the corresponding section of any future federal tax code.
Nonprofit Lobbying & Political Activities
Engaging in political or lobbying activities is an extremely slippery slope for 501(c)(3) organizations. There are different rules that apply to political activities (ie. campaign contributions or activities for or against a candidate) and lobbying (ie. attempting to influence legislation). These rules also have different consequences if they are violated. These consequences could mean the denial or revocation of an organization’s 501(c)(3) status and the IRS imposing taxes on the organization. Whether an organization is violating these rules depends on 1) the type of organization (there are different rules for private foundations than other 501(c)(3) organizations); 2) the type of activity at issue (political or lobbying); and 3) the scope or amount of the activity conducted.
What to Do if You Qualify for Tax Exempt Status
If you think your organization qualifies for tax exempt status, the next step is to complete and file an IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. As you can see from the above, getting tax exempt status requires the organization to jump through a number of hurdles. This is done in the 1023. While some organizations attempt to complete the 1023 on their own, this could lead to massive delays in obtaining the organization’s tax exempt determination letter. Instead, a much better route is to hire an attorney who is well versed in tax exempt organizations. I have helped numerous organizations obtain their tax exempt determination letter. Continue reading about my IRS Form 1023 preparation services.
Learn more about what the Neal Law Firm can do for your charity.