Obtaining 501(c)(3) tax exempt status is a crucial step for nonprofit organizations.
501(c)(3) status, granted by the Internal Revenue Service (IRS), offers numerous benefits, including tax exemptions, increased credibility, and access to grants and donations.
We'll walk you through the essentials of 501(c)(3) tax-exempt status, from understanding the requirements and application process to maintaining compliance and understanding the benefits.
Table of Contents
Nonprofit vs Tax-Exempt Organizations
Types of 501(c)(3) Tax-Exempt Organizations
Requirements of a 501(c)(3) Organization
How to Apply for a 501(c)(3) Status
Benefits and Disadvantages of 501(c)(3) Tax-Exempt Status
5 Benefits of a 501(c)(3) Nonprofit Status
4 Disadvantages of a 501(c)(3) Nonprofit Status
Summing Up on 501(c)(3) Tax Exempt Status
FAQs on 501(c)(3) Organizations
What is 501(c)(3)?
Section 501(c)(3) is a specific tax category for nonprofits under the Internal Revenue Code, allowing tax exemptions for nonprofits. The Internal Revenue Code is the tax law issued by the United States Treasury through the IRS.
The IRS recognizes over 30 types of nonprofits but, only those with 501(c)(3) status can claim tax-deductible donations.
Organizations with 501(c)(3) status receive donations and nonprofit grants from the US federal government. As tax-exempt entities, they can apply for:
- Government and corporate funding
- Individual donations
- Foundation grants
501(c)(3) organizations rely on private contributions, grants, and fundraising efforts to cover operational costs, such as administrative and program expenses. While they may charge fees for certain services or events, most of their revenue comes from donations and grants rather than earned income.
They operate with a purpose exclusively recognized by the IRS, which includes:
- Charitable
- Religious
- Educational
- Scientific
- Literary
- Testing for public safety
- Fostering national or international amateur sports competitions
- Preventing cruelty to children or animals
Nonprofits must maintain their purposes and operations to qualify as charities under federal law. The IRS defines charitable activities under these categories:
- Relief for the poor, distressed, or the underprivileged.
- Advancement of religion, education, and science.
- Establishing or maintaining public buildings or monuments.
- Reducing the burden on the government.
- Reducing neighborhood tensions.
- Eliminating any discrimination.
- Defending human and civil rights granted by the law.
- Combating community deterioration and juvenile neglect.
Steps to Register for 501(c)(3) Status
Registering your organization with the IRS is the first step if you want to start a nonprofit. After registration, you can deduct some non-monetary charitable contributions like:
- Volunteer hours
- In-kind donations
- Equipment used
Organizations with 501(c)(3) nonprofit status are exempt from paying federal income tax on donations. 501(c)(3) organization donors can deduct their contributions when filing personal income taxes, reducing their taxable income.
While nonprofits can operate without 501(c)(3) designation and still accept donations, this tax exempt status is mutually beneficial. Nonprofits receive support without taxation on donated funds, and donors receive tax deductions for their charitable giving up to 60% of their adjusted gross income.
For donors to claim a tax deduction, the recipient must be a qualified 501(c)(3) tax-exempt nonprofit organization.
501(C)(3) Documentation and Regulations
A 501(c)(3) nonprofit can be a corporation, trust, limited liability company (LLC), or unincorporated association. It must follow the organizational regulations of its underlying business model.
As a corporation, you’ll have articles of incorporation with bylaws dictating how to run your nonprofit. They will be the primary documents that form your organization. These articles will:
- Register your nonprofit with the government.
- Explain your nonprofit’s purpose and mission.
- Establish your board of directors.
The board of directors plays a crucial role in overseeing the governance and strategic direction of the organization. The executive director, hired by the board, is typically responsible for the day-to-day management of the organization, including hiring and supervising staff.
It's important to note that not all nonprofits have paid staff, and the decision to hire employees depends on the organization's size, needs, and financial resources.
While reviewing the tax filing, if you are caught paying hefty salaries and using the status to gain tax exemptions, it will be revoked.
Nonprofit vs Tax-Exempt Organizations
The terms tax-exempt organization and nonprofit are often used interchangeably, but not all nonprofits have tax-exemptions.
Even with a tax-exempt status, a nonprofit has to pay taxes. Organizations with tax-exempt status are excused from paying federal corporate income tax on revenue generated from activities related to their purpose.
The organization must pay federal corporate income tax on the income from business activities apart from tax-exempt purposes, termed unrelated business income tax (UBIT). The tax rate for UBIT is currently at 21%.
Revenue from advertising is the most common form of UBIT. Tax-exempt entities are restricted on how much they can earn without compromising their exempt status.
Types of 501(c)(3) Tax-Exempt Organizations
The IRS defines three main types of organizations it will allow to operate under section 501(c)(3). All three organizations must have a nonprofit board of directors to handle crucial responsibilities.
1. Public Charity
Public charities are the primary type of 501(c)(3) organizations. These nonprofits have active programs and receive a large part of their funds from the government or the public.
Examples include:
- Educational organizations
- Animal welfare agencies
- Medical research organizations
- Food banks
- Relief organizations
- Environmental organizations
- Human rights organizations
To qualify as a public charity under 501(c)(3), an organization must receive at least a third of its total support from the general public, including individuals, corporations, and other public charities.
Individual donors can receive a tax deduction on donations covering up to 60% of their income. Tax deductions for corporations are usually limited to 25%.
The board of directors of public charities must be comprised of individuals not related by blood, marriage, or other business connections.
2. Private Foundation
A private foundation is referred to as a non-operating foundation, as they usually do not have any active programs.
Unlike public charities, these nonprofit organizations do not require public support, and revenue may come from a smaller donor base.
These organizations often support the programs of public charities with a similar tax-exempt purpose through grants. Donations to these nonprofits can be tax-deductible to individual donors up to 30% of their adjusted gross income.
Private foundations are required to spend a certain amount of money or property for charity annually. Failing to do so may lead to a 30% excise tax under section 4942 on the undistributed income.
The governance of a private foundation is also distinct from public charities and is more closely knitted. For example, a family foundation is a private foundation run and managed by one family.
Private Operating Foundations (POFs)
Private operating foundations have active programs like public charities with attributes similar to those of private foundations.
The IRS defines a private operating foundation as: “any private foundation that spends at least 85 percent of its adjusted net income or its minimum investment return, whichever is less, directly for the active conduct of its exempt activities.”
POFs must also meet one of the following tests:
- Assets test
- Endowment test
- Support test
Unlike private foundations, private operating foundations are not liable to pay a 30% excise tax on failing to distribute income.
They can also receive qualifying distributions from a private foundation, given that the institute does not manage them.
These nonprofits have a close governance like private foundations and are usually considered hybrids. Tax deductibility on individual donations to these nonprofits is limited to 50% of an individual donor’s adjusted gross income.
3. Churches and Religious Organizations
Churches, religious schools, and other religious organizations are eligible for a 501(c)(3) tax-exempt status.
Churches and religious organizations do not require formal recognition or have to file annual tax returns while submitting a 501(c)(3) application.
Church groups do not need to formalize their 501(c)(3) designations but they must fulfill the exact requirements as other charitable organizations.
Requirements of a 501(c)(3) Organization
Apart from the purpose approved by the Internal Revenue Service, a charitable organization must fulfill other requirements to be credited as a 501(c)(3).
- A charitable organization must not serve any private interests to acquire tax exemption under section 501(c)(3). This includes the interests of:some text
- Founders
- Family of founders
- Shareholders
- Designated nonprofit members
- No amount from a nonprofit’s revenue can be used to benefit private shareholders. The money is solely meant for the charitable cause.
- A 501(c)(3) charity cannot use its activities to influence legislation or participate in campaign activities to support or oppose a political candidate.
- Nonprofits must pay a reasonable salary to their employees based on fair market value (FMV).
- The 501(c)(3) status is valid till a nonprofit exists, given that it remains true to its purpose. A nonprofit must notify the Internal Revenue Service of any changes in its operations and mission.
- Nonprofits are exempt from federal corporate income taxes but must withhold the tax from their employees’ salaries. They must also pay Social Security and Medicare taxes.
How to Apply for a 501(c)(3) Status
1. Choose a Purpose for Your Nonprofit
3. File for 501(c)(3) Tax-Exemption with the IRS
4. Meet All State and Local Requirements
5. Maintain Your Nonprofit Status
1. Choose a Purpose for Your Nonprofit
Your nonprofit must pursue one of the purposes dictated by the federal tax laws. Ensure that the nonprofit is designed to benefit the public.
Ask questions like:
- Who will benefit from your nonprofit offerings?
- What is your nonprofit’s mission? Write down a mission statement to set clear goals.
- Where will you accomplish your nonprofit goals? What is the scope of your initiatives? Is it a local, state, or regional project? Will it create an impact internationally?
- How will you accomplish your goals? What will be your fundraising plan?
Answering these questions will help you build a strategic plan for your nonprofit.
2. Form a Corporation
Corporations are established at the state level; find out about the regulations of the state in which your organization will be based. The general steps will include:
- Naming the corporation: Select a unique name that reflects your nonprofit’s mission. Check with the Secretary of State to see if it's available. Head to the US Department of Commerce website to ensure it’s not trademarked.
- Appointing a board of directors: When choosing board members, you should ensure:some text
- One-third of the board members should be capable of fundraising on your behalf.
- One-third of the board members are finance, marketing, or legal experts.
- One-third of the board members are connected with the community. They must have experience and expertise in your services to the community.
These are good pointers for balancing the skills and backgrounds of a nonprofit board, though not strict legal requirements.
Before initiating your search, you define each member’s roles and job descriptions.
- Filing the articles of incorporation: Incorporate in the state you are planning to conduct your charitable activities. Filing fees may vary from state to state. Remember that incorporation does not make your nonprofit tax-exempt.
- Holding a board meeting to organize the documents and bylaws: The bylaws will include internal operational regulations of your organization regarding:
- Organizational structure
- Meeting procedures
- Elections
- Voting rights
- Other organizational policies
Acquire a state tax identification number equivalent to an individual’s social security number. Ensure you have a business plan as a for-profit organization has.
3. File for 501(c)(3) Tax-Exemption with the IRS
After meeting state requirements for corporation establishment, apply for the 501(c)(3) tax exempt status.
- Apply for the federal employer identification number (EIN). You will need this number even if you do not have employees yet. Use the official Internal Revenue Service website to apply for an EIN.
- Fill in and deposit Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code.
You can fill out the 11-page form online. There are additional schedule forms that you must attach, depending on your organization type.
The Internal Revenue Service will approve your status based on the information provided in the form. Wait for the determination letter from the IRS. They will let you know if they need additional information while processing your application.
4. Meet All State and Local Requirements
After a federal tax exemption, you must be tax-exempt at the state and local levels. It will help you avoid paying state corporate income tax or property tax.
Although state requirements vary, IRS approval will be enough to get you nonprofit recognition in your state.
You will also need some other permits and licenses to operate. Ensure that you comply with building codes and other local rules.
Before starting operations, understand corporate requirements like:
- Holding meetings
- Keeping minutes
- Filing returns
5. Maintain Your Nonprofit Status
Maintaining a nonprofit status is a persistent process. Failing to do so can result in revocation of your 501(c)(3) registration.
Here are some guidelines to keep the status:
- Adhere to your purpose and operational structure.
- Hold regular board meetings and take notes of important matters.
- Comply with the annual requirements of the Internal Revenue Service to file Form 990 or Form 990-EZ. You will report your activities, governances, assets, and expenses in these forms.
- Get adequate public funding as 501(c)(3) charitable organizations are essentially for the public.
- Maintain spotless financial records to be ready for a sudden audit.
- Do not allow your organization to take part in any political campaigns.
- Do not support nonexempt purposes or illegal acts.
- Do not allow your organization’s activities to influence legislation.
- Avoid earning UBI through your nonprofit.
- If you have several employees, consider a qualified retirement plan for them. These are specialized plans for nonprofits and closely resemble 401k plans.
6. Collect Donations
Once your organization has obtained 501(c)(3) status, developing a fundraising strategy to support your mission is essential. This may include a mix of individual donations, grants, corporate sponsorships, and fundraising events.
To streamline your fundraising efforts, consider partnering with a platform like Zeffy, which offers a range of tools to help nonprofits collect donations, manage events, and engage with supporters.
Benefits and Disadvantages of 501(c)(3) Tax-Exempt Status
Founders start nonprofit organizations with a goal in mind: they have a vision for something they want to change or improve. A 501(c)(3) status can provide several advantages to help them reach these goals.
5 Benefits of a 501(c)(3) Nonprofit Status
Apart from tax exemption, nonprofits with 501(c)(3) enjoy the following benefits.
1. Eligibility for Public and Private Grants
Several government-supported grants and assistance from foundations are limited to public charities. Nonprofits with 501(c)(3) can utilize these grants to advance their initiatives.
2. Formal Structure
A nonprofit operates as a legal entity independent of its founders and other ventures.
Incorporation helps them put their mission and structure above the individual interests of people associated with the nonprofit.
3. Limited Liability
As the law suggests, a nonprofit's founders, directors, employees, and members are not liable for its debts. Although, some exceptions exist.
Someone connected with the nonprofit cannot use it to shield their illegal or irresponsible actions. Board members are responsible for completing their duties in the nonprofit's best interests. A failure to fulfill these responsibilities can result in their being held liable.
4. Lower Postal Rates
The United States Postal Service offers a lower postal rate to 501(c)(3) nonprofits on third-class bulk mailings.
5. Access to Lobbying
501(c)(3) nonprofits, except churches and private foundations, can make the 501 h election.
The 501 h election guides the definition of lobbying for 501(c)(3) public charities, which lets them participate in limited lobbying activities. It also suggests how much money they may spend on lobbying.
While lobbying activities attempt to influence legislation, they are not synonymous with political campaigns. Lobbying does not refer to campaigning for/against political candidates.
Electing for 501 (h) does not allow organizations to participate in political activity directly.
4 Disadvantages of a 501(c)(3) Nonprofit Status
While the benefits are laudable, some disadvantages should also be considered.
1. Administrative Costs
You need time and resources to create a nonprofit organization. Costs that entail include fees for:
- Applying for incorporation.
- Submitting tax-exemption request.
- Maintaining the nonprofit status through annual renewals.
Nonprofits may also need assistance from attorneys, accountants, and other consultants, which comes with additional costs.
2. Ongoing Paperwork
As tax-exempt corporations, nonprofits must maintain detailed records and submit annual filings to the state and Internal Revenue Service. There can be no gaps in bookkeeping, and the filings must go within the stated deadlines to maintain their tax-exempt status.
3. Shared Control
While nonprofit founders want to control their operations, 501(c)(3) does not give them that liberty. Personal control is limited within charitable organizations with 501(c)(3) tax-exemption status.
They are bound to laws and regulations, including their own bylaws and articles of incorporation.
4. Public Scrutiny
Serving the public interest is one of the core functions of a nonprofit organization. That's why the public can inspect a nonprofit's finances.
They can request federal and state filing copies of a charitable organization to learn about their expenses and salaries.
Summing Up on 501(c)(3) Tax Exempt Status
By obtaining 501(c)(3) status, nonprofits can take advantage of tax exemptions, increased credibility, and access to a wider range of funding opportunities.
Before sending the application, ensure you have a set purpose in mind. Get it approved by the Internal Revenue Service. Make sure your nonprofit meets all the requirements of section 501(c)(3).
To maximize fundraising efficiency, consider Zeffy, a 100% free platform that supports your 501(c)(3) nonprofit in managing donations, events, and donor engagement without any transaction fees.
FAQs on 501(c)(3) Organizations
What can a 501(c)(3) spend money on?
A 501(c)(3) charitable organization can spend on activities related to its tax-exempt charitable mission. No funds or assets should be used for personal benefit.
These activities can include organizing fundraisers, promoting your mission through different channels, etc. Ensure that you properly record and file these expenses.
Refrain from excessive compensation to avoid being flagged.
How long does it take to get a 501(c)(3) approval?
The timeline for obtaining 501(c)(3) approval can vary depending on the complexity of your application and the IRS's workload. On average, the process takes between 3 to 6 months from the date the IRS receives your complete application.
In some cases, expedited processing may be available if your organization can demonstrate a compelling reason for needing a faster determination.
The Internal Revenue Service does not respond to emails for status requests. To check your application status, you can:
- Call the Internal Revenue Service toll-free number
- Fax your information
- Mail them to the office address
How do you tell if a nonprofit is a 501(c)(3)?
To verify if a nonprofit organization has 501(c)(3) status, you can use reputable online tools such as ProPublica's Nonprofit Explorer or Charity Navigator.
These platforms allow you to search for organizations by name and provide information about their tax-exempt status, financial data, and IRS filings.
Alternatively, you can search for the organization using the IRS's Tax Exempt Organization Search tool, which provides a list of organizations eligible to receive tax-deductible contributions.
