A Not-For-Profit Corporation Is Not Automatically a Tax Exempt Organization.
There is often confusion between a not-for-profit corporation and a tax exempt organization. They are not necessarily one in the same. A not-for-profit corporation is organized under the law of a state for non-profit purposes. A tax exempt organization is a designation granted by the Internal Revenue Service of the Federal Government.
What is a Tax Exempt Organization?
A tax exempt organization is an entity granted immunity from taxation by the Federal Government in accordance with §501 of the Internal Revenue Code of the United States (26 U.S.C. §501). There are numerous types of tax exempt organizations; such as business leagues, chambers of commerce, real-estate boards and boards of trade. Most people wonder about §501 (c)(3) type tax exempt organizations. They have two principal characteristics. First, no corporate income tax is imposed on them by the Federal Government and often by state governments. There are some exceptions to this rule. Second, people who make donations to 501(c)(3) organizations receive a tax deduction in the amount of their donation.
Requirements for Tax Exempt Status
The Internal Revenue Code establishes three primary requirements in order for an organization to qualify as a 501(c)(3) organization:
- Appropriate Purpose: The organization must be operated exclusively for one of a number of purposes. These purposes are religious, scientific, literary, educational, fostering amateur sports competition, preventing cruelty to children, preventing cruelty to animals, or charitable purposes. Charitable purposes is a broad standard rather than a strict rule, but includes at least providing for the poor, lessening the burdens of government, eliminating prejudice and discrimination, defending civil rights, and reducing juvenile delinquency.
- Retaining Profits for Organizational Purposes: The organization may not distribute profits or other earnings to any individual, shareholder, member or non-tax exempt parent company. The prohibition on the distribution of profits to individuals, shareholders and members includes not only a prohibition on dividends and other direct disbursements, but also a prohibition on “excess benefit transactions”. “Excess benefit transactions” are “providing an economic benefit in excess of the value of the consideration received.” This prohibition is best understood as a rule preventing the organization from indirectly distributing profits to certain individuals by intentionally overpaying for a product, service, or other benefit.
- Restrictions on Political Activities: The organization is subject to an absolute prohibition on political campaigning which extends to both donating to campaigns and advocating on behalf of a person or political party. The organization is also limited in the types of lobbying activities they can engage in. These lobbying restrictions establish maximum amounts of money an organization can spend on lobbying, with the amount depending on the organization’s size and structure.
An organization that meets these requirements can become a 501(c)(3) in one of two ways. First, some organizations, such as religious organizations and small charitable organizations, automatically qualify. Second, filing Internal Revenue Service Form 1023 with the IRS and paying of a filing fee.
Types of 501(c)(3) Tax Exempt Entities
There are two principal types of 501(c)(3) organizations: public charities and private foundations. Each organization is governed by a different set of rules and regulations.
- Public Charity: A public charity is an exempt organization which receives most of its income from the general public and/or government. Think – United Way.
- Private Foundation: A private foundation is an exempt organization that receives the most of its income from the donations, investments and endowments of a limited number of individuals and/or entities. Private Foundations are governed by a more strict set of regulations than public charities. Think – Michael Jordan
Advantages of Qualifying as a 501(c)(3)
Qualifying as a 501(c)(3) brings several advantages, some of the most important are:
- Tax Exemption: One of the core advantages to qualifying as a 501(c)(3) is exemption from federal income tax, and often, exemptions from state and local taxes as well.
- Deductible Contributions: Donors to 501(c)(3) organizations receive a tax deduction.
- Reduced Postage Rates: Charitable entities receive reduced mailing rates for mailings related to the organization’s purpose.
- Employee Compensation Advantages: Employees of tax exempt organizations are eligible for tax-favored contributions to certain employee benefits programs under 26 U.S.C. § 403(b) (so-called “403(b) retirement plans”). 501(c)(3) organizations are also exempt from having to pay federal unemployment taxes under 26 U.S.C. § 3306(c).
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