Brief Overview
IRS 501(c)(3) Tax Exemptions

INTRODUCTION:
  • All Corporations Must File a Return Unless Exempt:  Every corporation, even nonprofits, must file a corporate income tax return UNLESS it has been granted an exemption by the IRS.

  • Types of Exemptions:  Section 501(c)(3) is one of many types of IRS exemptions.  A partial list of these exemptions include

    • 501(c)(3) - charitable, educational, and religious
    • 501(c)(4) - social welfare organizations
    • 501(c)(5) - labor organizations
    • 501(c)(6) - business leagues and chambers of commerce
    • 501(c)(7) - Social and Recreation Clubs
    • 501(c)(10) - Fraternal Societies
    • 501(c)(19) - Veterans' Organizations

ADVANTAGE OF 501(c)(3)
  • Contributions are tax deductible for the donor
  • Only 501(c)(3) organizations qualify for foundation grants.
  • Often government grants require that the applicant have a 501(c)(3) exemption

QUICK OVERVIEW OF THE QUALIFICATION PROCESS
  • First, create a nonprofit corporation by filing "Articles of Incorporation" with your state government.  This document MUST contain all of the IRS required language (in addition to the language required by state law).

  • Then, apply to the IRS for the exemption using either IRS Form 1023 or IRS Form 1023-EZ.

THE APPLICATION FORM
  • TWO FORMS TO CHOOSE FROM:  To obtain 501(c)(3) exempt status an application must be filed with the IRS using either the standard Form 1023 or the simplified on-line Form 1023-EZ.

  • IRS Form 1023:  The standard application form

    • filing Fee:  $600
    • CLICK HERE for complete information on Form 1023 (from the IRS Website)
    • CLICK HERE to see a sample of Form 1023 (the actual form is completed and filed on-line)

  • IRS Form 1023-EZ - Simplified on-line application for qualified smaller organizations

    • filing fee:  $275
    • CLICK HERE to review the IRS worksheet used to confirm eligibility for IRS Form 1023-EZ
    • CLICK HERE for a preview of what the on-line IRS Form 1023-EZ looks like (the actual form is completed and filed on-line)

QUALIFICATION TO BE A 501(c)(3) ORGANIZATION
  • WORKING DEFINITION:  a 501(c)(3) entity is a corporation that is "organized and operated" exclusively for charitable, educational, or religious purposes, no substantial part of whose activities involve trying to influence legislation, does not endorse political candidates, and does not operate for the "private benefit" of insiders (persons in a position to exercise substantial influence over the affairs of the organization) or some other small group of people (though it can pay reasonable compensation for services actually performed).

    • Now, let's break this down and look at each part of the definition.

    • ORGANIZATIONAL TEST: the corporation must be "organized" exclusively for an exempt purposes. To meet this test specific language must be included in the articles of incorporation.  Click Here to see the specific language that must be included.
      • .
    • OPERATIONAL TEST: An organization must "operate" "exclusively" for one of the following purposes: charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.  Here is a summary of the main exempt purposes recognized by the IRS:

      • "Charitable"
        • relief of the poor and distressed or of the underprivileged
        • advancement of religion
        • advancement of education or science
        • erection or maintenance of public buildings, monuments, or works
        • lessening of the burdens of Government
        • lessening neighborhood tensions
        • elimination prejudice and discrimination
        • defending human and civil rights secured by law
        • combating community deterioration
        • combating juvenile delinquency

            • Note that "lessening burdens of government" and "combating community deterioration" are general catch-alls which can cover many nontraditional charitable activities. Therefore, in the "narrative" section of Form 1023 there needs to be careful explanation of how the activity furthers a the "charitable purposes" (Form 1023-EZ does not require an attached narrative).

      • "Educational"
        • class room type programs
        • educating the public about important issues.

      • "Religious"
        • There is no set definition but the more a proposed activity looks like something that has traditionally been considered religious the more likely it is that the IRS will grant approval

TWO TYPES OF 501(C)(3) ORGANIZATIONS:
PUBLIC CHARITY vs PRIVATE FOUNDATION.
  • In granting 501(c)(3) status the IRS will classify the organization as being either a "public charity" or "private foundation". A private foundation is a 501(c)(3) entity that does not qualify as a public charity. The choice is made by the IRS and not the organization. The classification is based on the sources of the organization's support.

    • PUBLIC CHARITY (technically: "Publicly Supported Organization") is a 501(c)(3) organization that meets the 1/3 public support test, that is, it receives at least one third of its support from "public" sources such as small contributions, government grants, or from other public charities AND it does not receive too much income from investments. If an organization qualifies it will not be subject to the restrictions applicable to private foundations. For example, The Ford Foundation is a "private foundation" because it does not get any support from the general public or the government and it is not affiliated with or controlled by another organization which itself gets public support. In contrast, your local United Way is a "public charity" because it receives broad public support. Also, an organization that depends on government grants will likely be classified by the IRS as a "public charity" because government grants are considered a public support.

      • ADVANTAGES OF BEING A "PUBLIC CHARITY":

        • Private foundations have more restrictions on their activities

        • The rules governing the deductibility of contributions are more favorable.

        • For public charities there is no tax on its investment income [if it has any], while a private foundation must pay a 2% tax

      • The IRS considers certain organizations to be public charities simply by the nature of their activities (schools, hospitals, religious organizations, etc.) or because the organization is affiliated with or controlled by another public charity.

      • For most 501(c)(3) organizations, however, the IRS presumes that it will be a private foundation UNLESS that organization can overcome the presumption by demonstrating that a sufficient amount of its financial support comes from "public sources" [small contributions from the general public, grants from governmental agencies, and grants from other public charities].

    • PRIVATE FOUNDATION STATUS: A "private foundation" is any 501(c)(3) organization that has failed to demonstrate that it is a "public charity".  CLICK HERE to view an IRS publication called "An Introduction to Private Foundations".

      • Disadvantages

        • can only give money to a public charity
        • excise tax on investment income not given away as grants in a timely manner''
        • generally, gifts to a private foundation are not tax deductible
        • a private foundation cannot receive grants from another private foundation.

      • PRIVATE OPERATING FOUNDATION - A "private operating foundation" is a type of private foundation that might be an attractive option for an organization that can't qualify as a "public charity" yet wants to avoid some of the disadvantages of being a normal private foundation. Private operating foundations are less rigorously regulated by the IRS than other types of private foundations and, like public charities, they can offer their donors the possibility of getting a tax deduction for donations. Somewhat like a public charity they can qualify for certain types of grants from other private foundations. What distinguishes "private operating foundations"" from other types of private foundations is that they must devote most of their resources to the active conduct of its exempt activities (rather than simply making grants out of their investment income). CLICK HERE to get more information from the IRS website.

RESTRICTIONS ON 501(C)(3) ORGANIZATIONS:
  • NO UNDUE PRIVATE BENEFIT:

    • The organization must be deemed by the IRS to serve a public and not a private interest.  Individuals are allowed to benefit but only as part of the larger community and not as a privilege inherent with being an insider.

    • "Private Inurement" - The IRS, following an audit, can revoke a nonprofit's tax exempt status if it feels that the primary purpose is to benefit insiders or an overly small group of people rather than the exclusive furtherance of charitable purposes.  This can happen if the IRS feels that an insider has entered into one or more arrangements with the nonprofit and receives benefits greater than she or he provides in return.  The IRS refers to such insiders as "disqualified persons" - high-level managers, board members, founders, major donors, highest paid employees, family members of any of the above, etc. Private inurement can take many forms in the eyes of the IRS.  Examples include unreasonably high salary payments and business dealings where a disqualified person received a greater benefit that he or she provided in return.

    • "Intermediate Sanctions":  Historically, the only penalty available to the IRS with respect to an occurrence of private inurement was revocation of an organization's tax-exempt status.  Thus, the IRS had to choose between revocation and leaving the transaction unpunished.  The IRS adopted regulations in 1996 giving the IRS a new intermediate type penalty - thus, the provisions are referred to as "intermediate sanctions".  Although any finding of inurement by an organization may still result in revocation of the organization's tax-exempt status, the IRS may now impose intermediate sanctions as a less harsh alternative to revocation.  Under the new rule the IRS can focus the penalty on the individual wrongdoers rather than the organization itself.  Click Here for an article that provides more information on this topic.

  • LOBBYING: the basic rule is that a 501(c)(3) organization cannot attempt to influence legislation either by directly contacting decision makers or indirectly by urging others to do so. This includes local legislation pending before a city or county commission.

    • An "insubstantial" or incidental amount of lobbying is permitted if an organization is a public charity [see definition below]. These terms are difficult to quantify. Five percent is sometimes use used as an informal guideline, i.e., an organization's staff should not devote more than 5% of its time and or 5% of the organization's annual budget for lobbying. But this is not an official IRS guideline.

    • However, there is a "safe harbor". A public charity can make lobbying expenditures up to certain specified levels if it makes an "election" with the IRS using the designated form. Even if the organization exceeds the specified expenditure levels, the worst that can happen is that it will have to pay a tax of 25% of its excessive lobbying expenditures. It doesn't lose its exemption unless it keeps exceeding the limits in subsequent years. For more information go to Publication 557.

    • CERTAIN ACTIVITIES ARE NOT TREATED AS "LOBBYING". These include [1] talking to legislators about legislation that might affect an organization's tax exempt status or existence, but this does not include budgetary or funding matters: [2] activities related to non legislative decisions, such as opposing or supporting the issuance of regulations; [3] making available the results of nonpartisan studies; and [4] responding to requests to testify before legislative committees [your organization must be invited in writing by the chairman of the committee].

    • EDUCATING THE PUBLIC MAY NOT BE LOBBYING. Educating the public about an important issue is not lobbying so long as you don't directly urge people to contact their legislators. It is permissible to do "educational" activities such as nonpartisan research, policy papers, websites, newsletters, trainings, conferences, etc.

  • NO ENDORSING POLITICAL CANDIDATES: Section 501(c)(3) organizations cannot support or oppose political candidates. No partisan political campaign activities, however minimal, are allowed. Section 501(c)(3) groups can distribute nonpartisan "voter education" information, but such information should be carefully reviewed to make sure that it is a fair presentation of information about all candidates and is not "slanted". It cannot be anything that can be construed as an attempt to persuade the public one way or the other. Also, Section 501(c)(3) organizations are not permitted to allow groups or individuals to use their facilities and equipment to campaign for candidates.

GROUP EXEMPTIONS:
  • When the Nonprofit is a Local Affiliate of a Central Organization:  The IRS sometimes recognizes a group of organizations as tax-exempt if they are affiliated with a central organization. This avoids the need for each of the organizations to apply for exemption individually. A group exemption letter has the same effect as an individual exemption letter except that it applies to more than one organization.

  • CLICK HERE for an IRS information page on group exemptions

SPECIAL RULES FOR CHURCHES:
  • Unlike "charitable" and "educational" organizations,, "churches" can "self declare" themselves to be exempt under Section 501(c)(3) without having to submit a formal application to the IRS using either IRS Form 1023 or 1023EZ (Section 508(c)(1) or the IRS Code).

  • Even though not required, some churches will submit formal exemption applications to the IRS anyway so that the name of the church will appear in the IRS database of exempt organizations (so that potential donors can can confirm that the church in question is indeed exempt.  Churches are normally NOT required to file any version of Form 990 but they must follow all rules applicable to other 501(c)(3) organizations.