What's the Story on Nonprofit and Tax-Exempt Entities?

Have you ever wondered how you’re supposed to determine whether your organization is eligible for exemption from federal income tax? The possibility of being tax-exempt is permitted under section 501(a) of the Internal Revenue Code.

But what about determining private foundation status? Well, that is covered by section 501(c)(3) of the Internal Revenue Code. Let’s explore the differences between the two.

How do you apply for tax-exempt status?
If you want to apply for exemption from taxes, you’ll need to figure out whether your organization is categorized as a trust, a corporation, or an association.
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Here’s how these three categories differ:

• A trust refers to a situation where one person holds the title to the property, and the circumstances are subjected to an obligation whereby the person with the title must keep or use the property for the intended benefit of another individual.
• A corporation is an entity that files articles of incorporation in a state where said articles are generally date-stamped prior to being put into effect.
• An association is a group of people who come together for a specific cause. Associations are backed by written documents — like articles of association — that indicate and prove their date of creation. The document must be signed by at least two people, and it must be dated as well. While this is the general definition of an association, please note that the definition where you live can differ as the definition varies under state law.  

Once you’ve taken care of the paperwork for your organization, you’ll need to determine which type of tax-exempt status you would like to pursue. You’ll need to fill out an application for recognition of tax exemption, and it needs to be submitted electronically via the Pay.gov website. The form that you’ll use and submit is known as Form 1024-A, Application for Recognition of Exemption.

What does it mean to be tax-exempt?
Organizations that are exempt from federal income tax are known as charitable organizations. Additionally, if organizations have been assembled and continue to operate exclusively for any of the following reasons, then they are tax-exempt as long as they meet requirements set forth by Internal Revenue Code 501(c)(3):

• Religious.
• Charitable.
• Scientific.
• Public safety.
• Literary.
• Educational.

​These types of organizations often include social welfare organizations, civic leagues, social clubs, labor organizations, and business leagues, among others.

Publication 557 discusses the rules and procedures that you must follow if you wish to seek your organization’s recognition of exemption from the responsibility of paying federal income tax. If that is something you are interested in, you’ll need to follow the instructions prior to obtaining an appropriate determination letter, which is what recognizes your organization’s exemption from federal taxes.

As you learn more about tax exemption, you’ll likely come to learn that there are many annual filing requirements that must be met in order to keep your tax-exempt status in effect. You can find links on the official IRS website when it comes to exempt organizations. There, you will also see what the various registration requirements are for charities as well as details pertaining to taxation, the employers of nonprofits, and more.

Even though associations are generally organized while operating as both nonprofit and tax-exempt entities, there are some associations out there that are nonprofit yet not exempt from paying federal taxes. This is because the requirements for federal income tax exemption are more detailed and complex than the requirements for nonprofit corporation status. However, this is rare, so it likely does not relate to your situation.

Make sure you understand the relevant terms for your situation
It’s easy to confuse the terms nonprofit and tax-exempt. This confusion is quite understandable. However, it is important to note that the concepts are completely different from one another.

Nonprofits are organizations that serve a public purpose. Instead of providing financial benefits to one person, corporation, or entity, nonprofits work to benefit people as a whole. Just make sure you check with your specific state of incorporation for clarification.

Also, please note that it is acceptable to incorporate in a state outside of where you physically live if you are in search of requirements that are more favorable for your situation. Additionally, the application process for tax exemption is fairly long.

The forms are approximately 30 pages in length, and the IRS advises that people should allocate about eight hours to complete them. From there, you might have to wait upwards of several months before you learn whether you have been granted a tax exemption status or not.

Several weeks after you complete the forms, the IRS will inform you that your application has been received. From there, the IRS will assign you to an exempt organizations specialist if additional information is needed from you.

You can always check the IRS’ official website for updates, but it’s fine to await contact from the IRS instead. You’ll also receive a letter of determination that denotes the IRS’ decision to either approve or deny your application for tax exemption. This documentation will also prove your tax-exempt status on a more permanent basis as long as you are accepted.

The bottom line? Don't go it alone. Consult with financial and legal professionals who are well versed in all things tax-exempt for nonprofit organizations.