Overview of 501(c)(3)

Brief Overview
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 commers
501(c)(7) - Social and Recreation Clubs
501(c)(10) - Fraternal Societies
501(c)(19) - Veterans' Organizations

ADVANTAGE OF 501(c)(3) EXEMPTION

Contributions are tax deductible for the donor
Only 501(c)(3) organizations qualify for foundation grants.

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 choices)

IRS Form 1023: The standard application form

filing Fee: $850
only $400 if organization's annual gross receipts aren't expected to exceed $10,000

IRS Form 1023-EZ - for qualified smaller organizations

Much simpler. Filed using an on-line form
The filing fee is only $275
To determine eligibility complete an IRS Worksheet

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 (members, founders, directors, etc,) 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 explaination 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

NO EXCESSIVE PRIVATE BENEFIT.

The organization serve a public and not a private interest.

The organization can't be primarily for the benefit of designated individuals or "insiders" (such the founder or his family members).

Individuals are allowed to benefit but only as part of the larger community and not as a privilege inherent in their insider status.

If the IRS determines that the main purpose is to bring private benefit the exemption may be denied

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 "publicly charity". CLICK HERE to go to an information page on the IRS website

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 IRS will take away your tax exempt status if feels that the primary purpose is to benefit insiders or an overly small group of people rather that the exclusive furtherance of charitable purposes. This can happen when an insider enters into an arrangement 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. This is called "private inurement". It can take many forms. Examples include unreasonably high salary payments and certain types of business dealings between the corporation and its directors and officers. This is a MAJOR concern of the IRS and many of the questions on the application (Form 1023) have to do with potential private inurement.

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 designaged 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:

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.