A non-profit organization may obtain an exemption from federal income taxation if its purposes and activities conform to those listed in the Internal Revenue Code (IRC). The vast majority of tax-exempt organizations are based on section 501(c)(3) of the IRC, meaning that they are organized and operate for one or more of the following exempt purposes: charitable, educational, religious, scientific, literary, testing for public safety, fostering national or international amateur sports competition, or preventing cruelty to children or animals.
The terms “non-profit” and “tax-exempt” are not synonymous. A non-profit is a type of business entity formed by filing a formation document (Articles of Incorporation if a corporation or Articles of Organization if a LLC) with the Secretary of State. This alone does not afford the entity tax-exempt status. A tax-exempt organization is a non-profit whose application for exemption has been approved by the IRS. See the IRS’ page on the Difference Between Nonprofit and Tax-Exempt Status.
Every organization that qualifies for tax-exempt status under section 501(c)(3) is classified as either a Public Charity or a Private Foundation. The main distinction is that Public Charities have broad sources of financial support and broad public involvement, while Private Foundations have limited sources of financial support and limited public involvement. Typical public charities include churches, schools/colleges, hospitals, college endowment funds, governmental units, museums, and libraries. Typical private foundations collect donations or accumulate investment income to make grants to other charitable organizations and individuals, rather than directly operating charitable programs themselves.
An organization that receives tax-exempt status is classified as a Private Foundation unless it requests and qualifies as a Public Charity. Essentially, a Public Charity must prove in its application that it does or will receive broad support from the general public, governmental units, or other tax-exempt organizations rather than from private funding or gross investment income. A Public Charity is preferred because it will not be subject to a 1-2% tax on net investment income applicable to Private Foundations. Also, contributors may deduct up to 50% of their adjusted gross income if donations were made to Public Charities, whereas the IRS allows up to a 30% deduction for contributions made to most Private Foundations. However, a Public Charity will be expected to maintain the strict public support requirements and will be reclassified as a Private Foundation if it fails to do so.
To be recognized as exempt from federal income taxation, most organizations must apply for recognition of exemption. The only exceptions to this requirement are churches (including conventions or associations of churches or integrated auxiliaries of a church) and small public charities normally having annual gross receipts of less than $5,000. But even these organizations frequently apply so that they may receive an IRS Determination Letter proving their tax-exempt status.
Aside from exemption from federal income tax filing and payment, several other tax benefits are conferred on approved organizations. Section 501(c)(3) organizations may claim exemption for federal unemployment tax otherwise payable on employee wages. Kentucky corporate income tax is not imposed on entities exempt under section 501 of the Internal Revenue Code or religious, educational, charitable, or like corporations not organized or conducted for profit. KRS 141.040(1). Tax-exempt organizations may obtain exemption from Kentucky sales and use taxeson purchases of tangible personal property, digital property, or services.
Other benefits include:
- The U.S. Postal Services offers reduced rates for mailings by tax-exempt organizations.
- Only tax-exempt organizations are eligible for numerous government grants and contracts.
- Volunteers may be used more extensively without violating federal or state labor laws
- An IRS Exemption Letter is occasionally a prerequisite to opening a non-profit bank account
Finally, tax-exempt organizations usually find it much easier than non-exempt business entities to secure contributions from donors. The IRS confers tax-exempt status only upon organizations with valid charitable purposes, activities in keeping with such purposes, solid governance structures, and the like. When obtained, the organization gains credibility with potential donors. Additionally, only contributions to tax-exempt organizations will be tax-deductible for federal income tax purposes. Organizations which have not yet received federal tax-exempt status cannot assure potential donors of this benefit.
Frequently Asked Questions
- What is the difference between a non-profit, tax-exempt organization and a for-profit, tax-paying business?
- A non-profit may conduct the same degree of business activities as a for-profit company but cannot let the business profits benefit private individuals. If it conducts business activities unrelated to its exempt purposes, such activities cannot dominate its operation and taxes will be owed as if it were a for-profit business. A non-profit may pay its employees “reasonable compensation” and will have to submit annual tax filings to prove its continued worthiness for tax exemption, but will avoid most taxes. Additionally, a non-profit will lose its tax exemption if it lobbies extensively or engages in political campaign activity.
- What startup tasks must be completed before applying for tax-exempt status?
- The organization must be formed with the Secretary of State. The business formation document must meet the IRS’ organizational test for purposes and powers, fulfill the permanent dedication of assets requirement, and commit to specific Internal Revenue Code compliance if the organization is a private foundation. The business formation document (either the Articles of Incorporation or the Articles of Organization) must be included with the exemption application. Problems with either document will prevent the issuance of tax-exempt status.The organization must have an EIN (federal tax ID number) issued by the IRS.The organization should also have its business governing document drafted, as this answers some questions the IRS will have about the organization when reviewing the exemption application. If a business governing document exists, (either the Bylaws or the Operating Agreement) it must be included. See IRS Publication 557, Chapter 1.
- What types of tax-exempt organizations are there other than 501(c)(3) organizations?
- There are various organizations whose exemption is derived from another section of the Internal Revenue Code: civic leagues, social welfare organizations, labor organizations, agricultural or horticultural organizations, business or professional leagues, social and recreational clubs, fraternal societies, and veterans’ organizations. While such organizations may be exempt from federal income taxation upon filing Form 1024, donations to such organizations are usually not deductible. See the IRS’ page on Types of Tax-Exempt Organizations.
- What is a group exemption?
- A group exemption allows multiple organizations to claim federal tax exemption without separately applying if affiliated with a central tax-exempt organization. The central organization has one or more subordinate organizations under its control. The subordinate organization is a chapter, unit, local branch, etc. of the central organization. Examples of subordinate organizations include church denominations, Boy Scout troops, and fraternity chapters.The central organization may apply for a group exemption letter at the time it applies for its own exemption or after. The group exemption application fee is $3,000. Once granted, the central organization may add subordinates to the group exemption so long as the subordinates would not be considered private foundations if they were to separately apply. The subordinates do not receive their own determination letter, so their tax-exempt status must be verified by checking with the central organization. For more information see IRS Publication 4573, Group Exemptions.
- Will the application for tax-exempt status be made public?
- Under IRC 6104, the IRS will make the application for tax exemption and all schedules, attachments, and amendments available for public inspection. In addition, after tax exemption is awarded, the organization must make its application form available to the public for inspection upon request.The IRS allows organizations to request that certain material not be made publically available. The type of material that may be redacted includes trade secrets, patent information, and the like. The organization should make this request when initially filing the application.
- By when must an application for tax-exempt status be filed?
- An existing organization must pay income taxes and file returns before and until an exemption application is approved. If granted, the exemption will be recognized only from the postmark date the application was received by the IRS.A new organization may avoid paying federal income taxes and filing returns if its application is approved within 15 months from the end of the month in which the organization was formed with the Secretary of State. A 12-month extension may be granted meaning that the IRS may retroactively recognize the exemption 27 months after formation. See IRS Publication 557, Chapter 3. The IRS allows organizations to apply in advance of operations if the organization can describe its proposed operations in enough detail to demonstrate it will meet the requirements for exemption.From a practical standpoint, the application should be filed as soon as possible after the organization is formed. This is because a tax-exempt organization appears more credible as a charity to potential donors than a taxpaying organization, and donors can only deduct contributions to tax-exempt organizations. Contributions made while the application is pending will be tax-deductible only if and when the application is approved.
- How long will it take the IRS to process the application?
- Assuming the IRS does not request any additional information, a Determination Letter is sent within approximately 90 days from the date the application was submitted. See the IRS’s page on “Where is My Exemption Application?”. The applicant will be contacted by the IRS if “further development” is required and the application will be delayed.The IRS lists the top 10 reasons for delays in processing exemption applications or for denying tax-exempt status. Such reasons include the failure to provide required information, enough information, attachments, or completion errors. Thus, it is important to accurately complete the application prior to submission.
- Will the organization be granted tax-exempt status if it submits an application with all required attachments, all items answered, and the proper filing fee?
- Not necessarily. First, there may be problems with the organization’s purposes, as declared in the application or the business formation document. Alternatively, the application may not have been completed correctly. If the organization “fails to furnish a sufficiently detailed description of its proposed activities to permit a conclusion that it will clearly be exempt,” the application likely will be denied. See IRS Publication 557, Chapter 1.The primary application Form 1023 is 30 pages long and requires numerous attachments or additional explanations. If the application is rejected, the IRS does not refund the $400 or $850 application fee.If you use our firm for your application, we thoroughly review your information before submitting the application so it is likely to be well-received by the IRS.
Legal Services Offered and Cost
Apply for Federal Tax-Exempt Status
Legal fees: $500 flat fee
- Determine appropriate type of tax-exempt organization and application Schedules that will be required
- Completion of IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code
- Submission of application, applicable Schedules, additional attachments, and filing fees to the IRS
- Correspondence with IRS regarding the application
- Forwarding of IRS Determination Letter when received
Note: The above service applies to organizations eligible to complete IRS Form 1023-EZ. The IRS estimates that 70% of organizations will be able to apply for a federal tax exemption using this form. We will confirm your firm’s eligibility to use this IRS form upon receipt of your information.
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