You need to follow the IRS rules carefully if you want your organization to be tax-exempt.
Most people start a business because they want to accomplish something or make money for themselves (usually both). But what if you want to do this for someone or something other than yourself? What if you want to start a successful charitable enterprise? This requires more than just choosing a form of organization.
Forming a tax-exempt organization
The tax-exempt organization is not really an entity choice, but rather a declaration of how your particular entity will conduct its business. When used in reference to nonprofit organizations, the term “tax-exempt” generally refers to net profits of an organization (income minus expenses) being exempt from state or federal taxes. While a nonprofit organization can be established by incorporating, the entity is not automatically tax-exempt upon filing the articles of incorporation with the state.
Tax-exempt status can only be achieved by applying and receiving approval from the Internal Revenue Service (IRS). The most common organization is called a Section 501(c)(3) public charity or private foundation, established for purposes that are religious, educational, charitable, scientific, literary, safety-oriented or amateur sports-related. (There are also a number of other IRS-designated organization types that are considered tax-exempt but not charitable. Examples include trade associations, social clubs and certain advocacy organizations involved in political lobbying. Check out the IRS classification chart for additional information.)
The application process is difficult, and professional help is recommended. It requires the filing of IRS Form 1023 within the first 27 months of the organization's formation. The form is quite lengthy, and a typical application package can range from 25 to 75 pages and take more than 100 hours to complete. A two-tiered filing fee structure ($300 and $750) allows very small organizations to apply at a reduced rate, compared to larger, more traditional tax-exempt organizations.
While the IRS generally rejects less than one-tenth of all applicants, another third are abandoned by the filer either out of frustration or inability to answer IRS follow-up questions. The process typically takes between two to 12 months, depending on the need for follow-up information. A negative determination by the IRS can be appealed, or the organization may choose to apply again, but either way it will be difficult once the initial application is rejected.
Most states do not require similar applications to be filed, although a handful of states do have a simple one- or two-page form that must be prepared. California is the only state that requires a separate application process rivaling the one required by the IRS. Moreover, in California, federal tax-exemption does not eliminate state income tax liability until approval is received from the California Franchise Tax Board.
After being granted tax-exempt status, the organization must continue to operate for the purposes for which it received its tax exemption. In addition, certain federal and state compliance filings may be required. Be sure to check with local authorities and consult your paid professionals before electing tax-exempt status for your organization.
Advantages of tax-exempt status. One of the primary benefits of being considered tax-exempt is the ability to accept contributions and donations that are tax-deductible to the donor. Additional benefits include, but are not limited to:
- Exemption from federal and/or state income taxes.
- Possible exemption from state sales and property taxes (varies by state).
- Ability to apply for grants and other public or private allocations 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.
Once an organization has been granted tax-exempt status, however, it does not have a blanket waiver of all tax obligations. Certain tax laws and liabilities will still have to be followed and paid. Private foundations may still be subject to taxes on investment earnings and undistributed minimum grant allocations. All tax-exempt organizations may be subject to taxes on “unrelated business income.” And of course, if you have paid employees, there is the issue of federal and state employment taxes that must be paid. Check with your state and local officials to see what applies.