501(c)(3) Tax Exemption
What Is 501(c)(3)?
Not All Nonprofits Are 501(c)(3)
Should We Be A 501(c)(3)?
How Do We Get 501(c)(3) Status?
Who Is Eligible Under 501(c)(3)?
Required Articles
How to Apply
Responding to Questions
Notification
Conclusion
Even if you are new to the non-profit world, you will soon hear
the term "501(c)(3)." What is it? Do you need it? How
do you get it? This Do It Right! Kit will help you understand.
What is 501(c)(3)?
Section 501 of the US Internal Revenue Code defines more than
30 categories of tax exempt organizations, from veterans organizations
to labor unions. Different tax rules apply to different categories.
If your organization will be seeking grants and donations, you will want to explore the requirements of Section 501(c)(3).
| Not All Nonprofits
Are 501(c)(3) |
| You may be thinking "We are already a non-profit. We filed
papers with the state." The state process to create a non-profit
organization is completely separate from the federal process
to determine its tax status. The federal process is much
more restrictive. Some non-profits will not meet the requirements
of Section 501(c)(3), but instead will fit under some other
category of Section 501. |
Should We Be a 501(c)(3)?
Qualifying under Section 501(c)(3) offers significant benefits:
- Exemption from payment of federal income tax
- Exemption from payment of federal unemployment tax
- Reduced postal rates
- Tax deductions to contributors for their donations
Perhaps most important, most foundations and other grantmakers will
only give grants to 501(c)(3) non-profits. Federal tax exempt status
provides them with some assurance that the organization serves some
legitimate charitable purpose, is not organized for someone's personal
benefit, and has at least a basic level of accountability.
If your organization is a loose, informal group with little money
or expenses, incorporation and 501(c)(3) tax exemption may be
unnecessary. Many small volunteer service and advocacy groups
exist with little or no money. They don't seek grants and their
members or contributors don't care if their gifts are tax deductible.
Even if you have some money or wish to seek an occasional grant,
you may not need to establish a separate non-profit 501(c)(3)
organization. You may partner with an existing 501(c)(3) non-profit
that would agree to serve as your "fiscal sponsor," administering
financial matters on your behalf. For more information on this
option, see CTAC's Do It Right! Kit on Fiscal
Sponsors.
Tax exempt status under Section 501(c)(3) also imposes significant
responsibilities:
- Limits the organization's purpose and activities
- Limits lobbying activities
- Prohibits political activities
- Prohibits excessive financial benefits to its directors and employees
- Requires tax returns
- Requires many records be open to public scrutiny
- Restricts certain distribution of assets if the organization is dissolved
Carefully weigh the benefits and costs of all your options before
you commit the time and money to a 501(c)(3) application.
How Do We Get 501(c)(3) Status?
If you have decided that 501(c)(3) tax exempt status is appropriate
for your organization, be prepared for the process. Because this
designation confers significant benefits on a non-profit organization,
the IRS carefully screens applications to weed out inappropriate,
ineligible or ill-prepared applicants.
The process may take a year or more and you may have to respond
to IRS requests for additional information, often on a short time
deadline.
Who Is Eligible Under 501(c)(3)?
First, the non-profit organization must be legally established
under the law of a state. If you are starting a new organization,
you will draft and file "Articles of Incorporation" with your state
government. You may consult an attorney, or contact the Secretary
of State office for forms and instructions. In Pennsylvania, see
CTAC's Do It Right! Kit on Incorporating
a Non-Profit.
501(c)(3) status is limited to non-profit entities that are organized
and operated for one or more of the following purposes:
- Religious
- Educational
- Charitable
- Scientific
- Literary
- Testing for pubic safety
- Fostering national or international sports competitions
- Preventing cruelty to children or animals
IRS
Publication 557 explains these categories further. Most
community development non-profits will apply under the broad sounding term "charitable",
but not every non-profit purpose will qualify under the IRS definition
of the term.
Required Articles
To qualify for 501(c)(3) tax exemption, certain provisions must
appear in the non-profit's Articles of Incorporation or By-Laws.
If you are starting a new organization, you can save time and
money by including these provisions in your original filing. If
you have an existing non-profit, you will need to obtain copies
of your organizational documents on file with the Secretary of
State and make amendments as needed.
The following provisions are required:
- A statement that profits or funds will not inure (be paid)
to any members. Of course the organization can pay its employees
appropriate compensation.
- Sample: No part of the Corporation's net earnings
will inure to the benefit of members, directors, or other private
persons except that the Corporation shall pay reasonable compensation
to staff for services rendered.
- A statement that if the corporation dissolves, its remaining
funds will be given to another tax-exempt organization according
to the requirements of Section 501(c)(3) of the Internal Revenue
Code.
- Sample: Upon dissolution of the Corporation, assets
shall be distributed for one or more exempt purposes within
the meaning of Section 501(c)(3) of the Internal Revenue Code.
- Be sure that your statement of purpose, or Mission Statement,
is consistent with the IRS regulations for tax-exempt activity.
Your Mission Statement should briefly describe your purpose
and then add the following:
- Sample: The Corporation is formed solely for charitable
and educational purposes within the meaning of Section 501(c)(3)
of the Internal Revenue Code.
- A Statement that the corporation will not lobby extensively
or support or oppose candidates for public office.
- Sample: No substantial part of the Corporation's
activities will consist of carrying on propaganda, or otherwise
attempting to influence legislation. The Corporation will not
participate in any political campaign on behalf of or in opposition
to any candidate for public office.
How to Apply
First, obtain current forms and instructions direct from the
IRS. You can call (800) 829-3676 or visit the World Wide Web at
www.irs.gov/charities.
Order or download the following items:
In addition, some organizations may need to file other IRS forms depending
on the type and length of their activities. Look through the list
of forms and publications for anything that may be relevant to
your organization.
Make several copies of the forms to use for working
drafts. After reading the instructions and Publication 557, fill
in as many of the blanks as you can. If you still have some blanks,
read the instructions and Publication 557 again, and then yell
for help.
You can seek assistance from an attorney or accountant, but find
one with experience with non-profits. You can seek out a local
technical assistance provider, such as CTAC. You can also call
the IRS Exempt Organization Office at (877) 829-5500.
The financial pages are a common sticking point for applicants.
If your organization has been in existence for more than one year,
you must provide the current year's data plus up to three previous
years of actual revenue and expense information. If your organization
is less than one year old, you must provide the current year's
data and two years of projected revenue and expense.
Remember, the IRS wants to see if your organization has a broad base of public support. If it doesn't, your organization may be classified as a "Private Foundation" and be subject to different tax rules. Take great care
with this section and read the IRS definitions for the various
categories.
They also want to see that your dollars are being spent on the
charitable activities you described, that funding is broad enough
to qualify as public charity and that the organization is not
overly influenced by a small number of people. Otherwise, you
will be classified as a private foundation.
When you have completed your draft, ask a qualified attorney,
accountant or technical assistance provider to review it with
you. Incorporate their suggestions if applicable, and prepare the
final version of the form.
Sign it, prepare a check for the application fee, gather up the attachments and mail the whole package to the IRS.
Responding to Questions
It is not uncommon for the IRS to take months to review your
application and then play "20 Questions" with you. They may ask
for more information or documents, and they will set a deadline
for response. DON'T MISS THE DEADLINE.
Carefully prepare your response, collect any requested documents
and review it all with your lawyer, accountant or technical assistance
provider. Send it to the IRS by the deadline.
Notification
Eventually, you will receive notice of
the IRS decision. This is called a "Determination Letter," and
it is a key document that you will need for every grant application
you ever write, so guard it carefully.
If you are a new organization, you will receive a Preliminary
Determination. You may function as a 501(c)(3) tax exempt organization
for five (5) years, when the IRS will examine your activities
and financial information to see if you indeed met the requirements
as you projected. If you have, or if you applied with an existing
history of activities and financials, you will receive a Final
Determination.
Relatively few completed and timely applications are denied,
but if you are unsuccessful, contact the IRS and an attorney for
assistance with the appeal process.
Conclusion
The 501(c)(3) process is not easy, and it is not appropriate for every organization. Carefully evaluate your options, choose what's right for your organization and prepare for the process.
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