Tax Exemption for Non-Profit Entities

In order to qualify for tax-exempt status and the resulting benfits such as exemption from federal and state income tax and property taxes and reduced rate postage, a non-profit corportion must qualify for and must generally also apply for tax exemption.  A sampling of common misperceptions regarding tax exemption for non-profit corporations and other organizations are:

Non-profits are automatically tax-exempt upon incorporation.  Generally incorrect.  Although there are some exceptions on the federal level, generally, to receive an exemption from federal and state income and California sales and use taxes, a nonprofit corporation must apply for federal tax exemption on IRS Form 1023, and if necessary, for California state tax exempt status on Franchise Tax Board Form 3500.  Additional tax exemption, registration, and licensing procedures may also apply to any given nonprofit, depending on a variety of factors.

All non-profits are 501(c)(3)'s.  Again, not true.  Some non-profits are not tax exempt at all, some are 501(c)(3) tax exempt entities, and some are tax exempt but not are not 501(c)(3) organizations.

501(c)(3) is often defined as a charity, but in fact 501(c)(3) is a subsection of the Internal Revenue Code under which charitable organizations engaged in one of the following activities may obtain exemption from federal taxation: charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and the preventing cruelty to children or animals.

There are other subsections of the Code under which a non-profit may apply for tax exemption.

All tax-exempt non-profits are public charities.  Some tax exempts are public charities, typically those with a broad base of financial support, as well as churches, schools, hospitals, and organizations that support other public charities.  Other tax-exempt nonprofits are private foundations.  Different IRS tax rules apply to each type of tax exempt organization, with the preference being for public charity status, if available.

Once I have my organization's 501(c)(3) tax status approved, I'm home free.  A separate state tax exemption may be necessary to avoid the imposition of state taxes on a non-profit.  A separate application and approval process may be required, and - as stated above - additional exemptions / approvals / registrations may also be required, for example, for sales/use tax and property tax exemptions.

Also, tax-exempts generally must still pay taxes on business income unrelated to their tax exempt purpose and payroll/employment taxes for their employees.  Finally, note that many tax-exempts must file tax returns, even if no taxes are owed, and that failure to act in conformance with law and with the charitable, social welfare, or public interest purposes may result in the termination of tax-exempt status.

I don't need an attorney to establish a non-profit.  Technically true, of course, but most will find the process challenging and not worth their time to get up to speed on the process and applicable laws.  Mistakes and missed steps are common in this area for do-it-yourselfers, who may tend to underestimate the amount of work and complexity involved.  While there is likely one out there somewhere, this office has yet to see a for-profit corporation or LLC that was set up optimally without the assistance of an attorney (a "one-step" process), let alone a tax-exempt non-profit (a "two-step" process: incorporation, followed by tax-exemption application).

I can earn a lot of money by starting my own non-profit corporation.  Non-profits are subject to numerous federal, state, and local laws, regulations, and restrictions.  The most basic principle of non-profits is contained in their name - they are not for profit in the sense that they cannot be owned or sold by, or operated for the benefit of, an individual, group of individuals, or regular (for profit) corporation or LLC.  Doing so constitutes fraud that various governmental agencies are always on the lookout for.  If you establish a non-profit, you may be able to serve on the board of directors and may possibly be employed by the non-profit; however, your compensation must be reasonable in relation to the number of hours you work for the non-profit, the type of work, your skill level, experience, and training in performing such job tasks.

In general, the more control and the more pay or benefits the founders or any small group of individuals are receiving from a particular non-profit entity, the more difficulty that entity is going to have obtaining and maintaining tax-exempt status.  In sum, a non-profit is a way to provide for others and for the community at large, not a road to riches for its founders.  Those who work for non-profits, whether they are founders, board members, or otherwise, generally make less than they could make working for a profit corporation.

My social or recreational club or neighborhood sports team won't qualify for tax exempt status because it's not like a 'real' charity.  Not necessarily, it may.  Internal Revenue Code Section 501(c)(7) may, under the right circumstances, permit your properly organized and operated social or recreational club or athletic league to incorporate as a non-profit and obtain tax-exempt status.

For more information, see also:

Nonprofit corporations, non-profit incorporation

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