Tax-exempt organizations: the basics
A 501(c) organization is a non-profit organization that does not have to pay most federal income taxes or state taxes. There are several main types of non-profit organizations, though they do not all enjoy the same tax designation across the board, as some non-profits must pay employee taxes. While non-profit status is determined by state law, tax-exempt status specifically refers to an organization being free from paying federal income taxes and is decided at the federal level.
Most tax-exempt organizations must still file annual tax returns, and penalties may be assessed for organizations that do not file or file late. If an organization does not file for three years straight, it loses its tax-exempt status.
Tax-exempt organization types
Charitable Organizations
A charitable organization is a non-profit organization that operates with philanthropic, religious, educational objectives in the interest of the common good. They must comply with the requirements laid out in Internal Revenue Code Section 501(c)(3).
Political Organizations
A party, association, committee, fund, or another type of organization organized for the purpose of accepting contributions or making expenditures.
Private Foundations
An organization with a single major source of funding, like gifts from a single wealthy family or corporation, rather than many small donations. The primary activity of most private foundations is to make grants to other charitable organizations and people, instead of directly operating their own charitable organization.
Churches and Religious Organizations
Churches and similar organizations qualify for federal income tax exemption under Section 501(c)(3).
Other
A variety of other organizations meet Section 501(c)(3) qualifications for tax-exempt status, including civic leagues, labor organizations, business leagues, and social welfare organizations.
How to apply for tax-exempt status
An organization’s non-profit status is determined by state law and summarized in the articles of incorporation and trust documents, which are important founding documents finalized and submitted to the Secretary of State’s office in the state in which the organization is formed.
Tax-exempt status, on the other hand, is governed by federal law, since it expressly refers to exemption from federal income taxes. The following are the key steps an organization must take to apply for tax-exempt status.
- Decide on your organization’s structure.
- Nonprofit corporation – An entity that operates for purposes other than turning a profit formed through the filing of articles of incorporation with the state government.
- Trust – An organization in which a single individual holds title to the property or properties. A trust is formed under state law through the use of specific language in its organizing documents.
- Association – A group comprising two or more people united for a specific purpose and formed by a written document like articles of association that includes specific language referring to the intent of the group.
- Prepare your organizing documents.
- Research the registration requirements in your state.
- File the appropriate form (determined by your organization’s structure) to apply to the Internal Revenue Service for recognition as a tax-exempt organization. Forms may be found on the IRS website.
- Acquire an Employer Identification Number (EIN) through the IRS. This can be done through a variety of means, including through the mail, via fax, or online.
- Don’t forget, you’ll need someone to receive service of process in Michigan, accept your mail Indiana, or receive a business filings in North Carolina
Requirements for maintaining tax-exempt status
After obtaining tax-exempt status, an organization must be vigilant in following the correct protocol in-order to remain tax-exempt. Certain violations, such as a repeat failure to file annual returns or improper business dealings, may result in a revocation of tax-exempt status and could prove the death knell for a nonprofit organization.
- File annual information returns with the IRS. Although there are a few exceptions (such as churches), a majority of tax-exempt organizations with gross receipts totaling $50,000 or higher are required to file Form 990, 990-N, or 990-EZ in order to report assets and gross receipts. An organization automatically loses tax-exempt status if it fails to file for three consecutive years.
- Avoid inappropriate lobbying activity and political campaigning. Though some lobbying is permitted for a tax-exempt organization, improper lobbying or too much lobbying may result in the IRS revoking 501(c)(3) status. In general, political campaigning, endorsements of a political candidate, or monetary contributions to a political campaign are not permitted.
- Report and pay taxes on unrelated business income. If your organization generates income of more than $1,000 on business or trade that is not related to its main purpose, it must file Form 990-T and pay taxes on the income.
- Keep good record books and provide written receipts for individual contributions. Accurate financial records are important because they provide substantiation for your annual tax returns with the IRS. Furthermore, any goods or services provided by your organization must be exchanged for a fair market value, or else they may appear suspicious.
- Follow nonprofit organizational guidelines and adhere to a strict process for business arrangements. For nonprofit corporations, this means appointing officers and a board of directors just like a for-profit company. The board of directors should meet regularly to discuss and approve business arrangements and follow a process for approving contracts and compensation agreements.
- When in doubt, consult legal counsel. If your organization is unsure if an arrangement or decision is acceptable in maintaining tax-exempt status, speak with an attorney well-versed in the IRS tax code before following through.
Voluntary Classification Settlement Program
The IRS established the Voluntary Classification Settlement Program (“VCSP”) in 2011 to allow employers to classify 1099 workers as W-2 employees for tax relief purposes. Organizations that qualify for VCSP pay just 10% of the employment taxes that would have been due if they had not been accepted into the program.
Tax-exempt organizations are eligible to participate in the VCSP if they meet all of the requirements. These requirements include treating workers classified as employees as independent contractors (Form 1099 filers), not being under the IRS tax audit or audit by any other state agency.
Organizations can apply for the VCSP by filing Form 8952, Application for Voluntary Settlement Program 60 days before treating its workers as employees. The VCSP only provides federal tax relief, not for possible state or local tax liabilities.
Find more information on The Pros and Cons of 1099 vs W2 here.
Work Opportunity Tax Credit for tax-exempt employers
If your nonprofit employed qualified veterans (or individuals in other qualified categories such as long-term unemployment recipients and ex-felons) that began work on or after December 31, 2014, and before January 1, 2020, your organization may be eligible for a work opportunity tax credit through the Protecting Americans from Tax Hikes Act of 2015 (“the PATH Act”).
The credit amounts to the total Social Security tax owed on wages paid to all of the organization’s employees within the period for which the credit is claimed. Tax-exempt organizations can claim the credit by first filing Form 8850, the certification request for the work opportunity credit, and following up with Form 5884-C once the certification request is approved and the employment tax return is claimed.
How tax-exempt employers can qualify for a Health Care Tax Credit
Smaller tax-exempt nonprofit organizations may qualify for the Small Business Health Care Tax Credit if they:
- Average employee salary is about $56,000 per year or less (in 2022)
- Pay at least 50% of the cost of employee-only (excluding families and dependents) health care coverage for all employees.
- Offer a qualified health care plan to employees with the Small Business Health Options Program Marketplace
- Have fewer than 25 full-time equivalent employees
Organizations can learn more about the tax credit at Healthcare.gov, and apply for the tax credit using Form 8941.
The maximum credit for small tax-exempt organizations is 35% of the total premiums paid. Tax-exempt organizations lacking taxable income may receive the credit as a refund on quarterly payments the organization has made for income tax and Medicare withholdings from employee wages.