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Obtaining Tax-Exempt Status for Your Organization

Most people start a business because they want to accomplish something or make money for themselves. But, what if your goal is to advance some charitable purpose or to benefit society, rather than earn a profit? In that case, you may wish to operate a non-profit, tax-exempt organization.

CT Tip: If you want to earn profits for yourself and benefit society, then you should investigate operating as a benefit corporation.

As the name implies, tax-exempt organizations do not pay federal or state income taxes on their net profits (income minus expenses). While freedom from income taxes is a significant benefit, there are other advantages to tax-exempt status as well. These include:

  • the ability to accept contributions and donations that are tax-deductible to the donor
  • exemption from state sales and property taxes in many (but not all) states
  • increased ability to apply for grants and other public or private allocations that are available only to IRS-recognized 501(c)(3) organizations.
  • potentially higher thresholds before incurring federal and/or state unemployment tax liabilities.
  • the public legitimacy of IRS recognition.
  • discounts on U.S. Postal bulk-mail rates and other services.

While there are a number of types of tax-exempt purposes in the Internal Revenue Code, the most common type is a Section 501(c)(3) public charity or private foundation that is established for religious, educational, charitable, scientific, literary, safety-oriented or amateur sports-related purposes. (Examples of other tax-exempt purposes include trade associations, social clubs, cemeteries, and certain advocacy organizations involved in political lobbying. Check out the IRS classification chart for additional information.)

Non-Profit Does Not Automatically Mean Tax-Exempt

While the first step in operating as a tax-exempt organization is usually forming a non-profit corporation, tax-exempt status is not automatic. It is necessary to apply and receive IRS approval to have tax-exempt status.

Although a non-profit is not automatically a tax-exempt organization, it is essential that the incorporation paperwork be prepared with the tax-exempt requirements in mind.

  • The organization’s purpose must be limited to one or more religious, educational, charitable, scientific, literary, safety-oriented or amateur sports-related purposes. It is prudent to specifically reference section 501(c)(3).
  • The organizing documents must provide that, in the event the organization is terminated, its assets will be distributed only for an exempt purpose under section 501(c)(3) or to the federal government.

Your organizational documents must reflect these requirements related to the purpose and disposition of assets. Having the purpose or stated in the bylaws or operating agreement is not sufficient. If the formation documents don’t specifically state an exempt purpose, they will have to be amended before you can apply for tax exempt status.

The request for tax-exempt status is made using IRS Form 1023, Application for Recognition of Exemption. Form 1023–EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, can be used by organizations that have assets of $250,000 or less and annual gross receipts of $50,000 or less.

Ideally, you should file Form 1023 within the first 27 months after you form your entity with the state. If your application is approved, you will have tax-exempt status retroactively to the date of incorporation or formation. If you delay past the 27-month filing window, you will have tax-exempt status as of the date of your application.

Form 1023 is complicated and requires many supporting documents, as well as payment of a filing fee which is based on the organizations actual or projected gross receipts. A typical application package can range from 25 to 75 pages and take more than 100 hours to complete.

CT Tip: The application process is difficult, and professional help is strongly advised.

Not only is the application complex, the approval process can take a long time to complete. (This is why having the retroactive tax-exempt date is valuable.) It can take up to a year, depending on the need for follow-up information.

Fortunately, most states simply accept the IRS’s designation of tax-exempt status, although a few do require filing an additional form.  California is the only state that requires a separate application process rivaling the one required by the IRS. And, in California, federal tax-exemption does not eliminate state income tax liability until approval is received from the California Franchise Tax Board.

Tax Exempts Have Ongoing Responsibilities

After being granted tax-exempt status, the organization must continue to operate for the purposes for which it received its tax exemption—or it will forfeit its tax-exempt status. And, it must comply with state requirements related to filing an annual report and maintaining a registered agent.

It is also important to realize that tax-exempt status is not a blanket waiver of all tax obligations. Certain tax laws must still to be followed and certain taxes paid. Although income related to the tax-exempt purpose is exempt from tax, all tax-exempt organizations may be subject to taxes on "unrelated business income." (For example, a church that operates a bookstore may have unrelated business income from the sale of books.) And, if you have paid employees, federal and state employment taxes must be paid.

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