501(c)(3) Guide for Nonprofits: What You Need to Know [2024]

‍Table of Contents

What is 501(c)(3)?

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

FAQs on 501(c)(3) Organizations

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What is 501(c)(3)?

Section 501(c)(3) is a specific tax category for a nonprofit corporation 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. 

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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

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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.

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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

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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 federal 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.

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What is a 501(c)3 VS 501(c)4?

A 501(c)(3) and a 501(c)(4) are both tax-exempt organizations under the U.S. Internal Revenue Code, but they have some key differences:

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501(c)(3) organizations:

• Purpose: Charitable, religious, educational, scientific, literary, testing for public safety, fostering amateur sports, or preventing cruelty to children or animals.

• Tax deductibility: Donations are tax-deductible for donors.

• Political activity: Limited. Cannot engage in substantial lobbying or any political campaign activities.

• Disclosure: Must disclose donors of $5,000 or more to the IRS (though this information is not made public).

• Examples: Libraries, religious organizations, etc.

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501(c)(4) organizations:

• Purpose: Social welfare or local associations of employees.

• Tax deductibility: Donations are generally not tax-deductible for donors.

• Political activity: Can engage in unlimited lobbying related to their mission and some political activities, as long as it's not their primary purpose.

• Disclosure: Not required to disclose donor information to the IRS.

• Examples: Social welfare groups and social welfare organizations, human and civil rights organizations/ organizations that ensure civil rights are secured, etc.

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Types of 501(c)(3) Tax-Exempt Organizations

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

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According to federal law, to qualify as a public charity under 501(c)(3), nonprofit organizations must receive at least a third of their 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. 

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2. Private Foundation

A private foundation is referred to as a non-operating foundation, as they usually do not have any active programs. 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.

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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.”

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POFs must also meet one of the following tests:

• Assets test

• Endowment test

• Support test

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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. 

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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.

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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 off:
  • 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.

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How to Apply for a 501(c)(3) 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. 

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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?

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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.

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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.

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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

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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),

• Fill in and deposit IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code and wait for the determination letter.

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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.

You will also need some other permits and licenses to operate. Ensure that you comply with building codes and other local rules. 

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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. 

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6. Collect Donations

Once your organization has obtained 501(c)(3) status, developing a fundraising strategy to garner charitable contributions, and 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.
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FAQs on 501(c)(3) Organizations

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