What is a Nonprofit Organization?
Nonprofit organizations are corporations set up to benefit particular interests rather than to generate a profit for shareholders. This does not mean that they can’t make a profit, but all profits must be reinvested into the organization. While nonprofits can pay salaries to employees and directors, they cannot issue dividends or other similar profit-sharing distributions. Nonprofits generally try to advance a certain cause or mission or meet a need of a particular community.
What makes a 501(c)(3)?
A 501(c)(3) organization is a certain type of nonprofit that receives tax-exempt status from the IRS. There are eight categories of nonprofits that are eligible to apply for 501(c)(3) status according to the IRS.
- Public safety testing
- Amateur sports competition
- Prevention of cruelty toward women, children, or animals
When forming a nonprofit corporation your articles of incorporation will need to include language that limits its purpose to one of these categories and restricts it from engaging in activities that do not further that purpose.
Aside from fitting into one of these categories, to qualify for this status your organization must fit one of three 501(c)(3) classifications. All three classifications are designed to support a non-discriminatory cause, mission, or community.
Public charities make up the largest share of 501(3)(c) organizations. These organizations carry out some type of direct charitable activity. Public charities are largely supported by donations from a wide base of groups and individuals.
The most important factor in determining if your organization qualifies for public charity status is the public support test. To pass, your organization must receive at least a third of its revenue from the general public, support from government agencies, or grants from organizations that get their support from the public. Public charities typically rely on many small donors for their support.
A private foundation is established to support other charitable organizations, rather than to engage in direct charitable operations. By default, most organizations that apply for 501(c)(3) status are presumed to be private foundations until they qualify for a different status.
Unlike public charities, private foundations receive their financial support from a small group of individuals, a family, or a corporation. This allows for a greater level of control over who sits on the board of directors and how funds are used. Private foundations are required to pay out a minimum of 5% of their revenue each year toward their charitable purpose.
Private Operating Foundation
Private operating foundations are essentially private foundations that are formed to engage in direct charitable operations. They are formed and operated in the same way as a private foundation, but use their funds towards their own cause rather than offering grants to third-party charitable organizations.
How to Become Tax Exempt
The following steps will help you plan and form your nonprofit organization:
- Plan your organization - 501(c)(3) organizations are tightly restricted, so it is important to meticulously plan your organization to ensure that it meets all requirements. You’ll want to be as specific as possible with your organization’s purpose, and have a plan for how it will be structured and run.
- Incorporate - Once you’ve got a plan, you’ll need to formally organize by forming a corporation. This includes deciding on a name, choosing a board of directors, drafting bylaws, and filing the necessary paperwork with your state’s business registration office.
- Apply with the IRS - Once your articles of incorporation are approved, you’ll need to apply for tax-exempt status with the IRS using Form 1023 or 1023-EZ, depending on your donations and assets. This step is critical. Be prepared to provide very detailed information about your organization, including its structure, finances, operations, and objectives. Once you’ve filed your paperwork, you can expect a response within 3 to 12 months.
- Comply - Receiving 501(c)(3) tax-exempt status can be a long and challenging process, so remaining compliant is extremely important. In addition to keeping meticulous records and following all required corporate formalities, your organization will need to file Form 990 each year with the IRS to detail your finances and operations.
What Benefits Do 501(c)(3) Organizations Receive?
501(c)(3) organizations come with several advantages. These include:
- Tax-exempt status - The most significant and obvious benefit is that 501(c)(3) organizations are tax-exempt. This means that they are not subjet to federal income tax, sales tax, or property tax as long as all revenue is used properly toward their charitable purpose.
- Tax-deductible donations - Donors to 501(c)(3) organizations can deduct their donations from their income taxes. This can help attract more donors to your organization.
- Grant eligibility - Most local, state and federal grants require that organizations have 501(c)(3) status to be eligible.
- Additional credibility - Receiving 501(c)(3) status can lend more credibility to your organization in the eyes of donors and other organizations.
- Discounts - Tax-exempt organizations can often receive discounts on things like postage and advertising.
What Drawbacks Are There in Forming a 501(c)(3)?
While the advantages of 501(c)(3) status are significant, there are also some drawbacks that come along with this distinction. These include:
- More restrictions and scrutiny on profits - Aside from a regular salary, profits cannot be distributed to members of the organization. You can expect the IRS to look very closely at your financial information. Bigger profits will invite more scrutiny, and if the IRS determines that the organization is too profitable, paying executives too much, or not sufficiently benefitting its intended cause or community with its profits, you may lose tax-exempt status.
- Limited political activity - Tax-exempt organizations are not permitted to endorse political candidates or donate to campaigns. There are also tight restrictions on lobbying.
- Individuals do not receive assets if the organization shuts down - Unlike a standard corporation, if a 501(c)(3) organization ceases operations, its remaining assets cannot be distributed to members. Instead, these assets must be distributed for authorized charitable purposes. A dissolution clause should be included in your bylaws to outline exactly how these distributions are to be made should your organization dissolve.
In addition to these restrictions, forming and maintaining a 501(c)(3) organization comes with a good deal of paperwork and some added expense. There may be more scrutiny from the public, as people tend to hold charitable organizations and their members to higher standards than for-profit corporations.
Maintaining Your Tax-Exempt Status
As you can see, it is not easy to qualify for tax-exempt status. After all the hard work you’ve done to receive approval, it is important to work just as hard to keep your status. Failure to continuously meet all of the requirements for a 501(c)(3) can result in a costly loss of that designation. Even if you are still meeting the broad requirements, your organization can lose its status if it changes its focus and starts supporting a cause or community not included in its original mission statement. Changes like this require you to file a Form 5768 with the IRS to maintain tax-exempt status.