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Becoming a Tax-Exempt Organization

Many nonprofit organizations wish to enjoy tax exemptions. These exemptions are offered by the Internal Revenue Service (IRS) and state governments. Groups seeking tax-exempt status must form the underlying organization as a nonprofit corporation. State nonprofit corporation laws govern the formation of these organizations. Each state sets specific rules and limits for qualifying nonprofit groups.

This article is for you if you're starting a nonprofit and want to learn about becoming a tax-exempt organization. Tax-exempt organizations do not pay federal income tax on the money they make. This can be a big help to groups trying to make a difference in their communities. Let's discuss what tax-exempt means, the benefits, and how to apply for it.

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Tax-Exempt Nonprofit Organizations: At a Glance

A tax-exempt organization is a special type of entity. These groups do not have to pay federal income tax on their earnings. These organizations are set up for different purposes and focus on a variety of missions. To be recognized as tax-exempt by the IRS, an organization must meet certain criteria. This criteria is outlined in tax law.

Tax-exempt status is beneficial for several reasons. However, obtaining and maintaining this status requires adhering to strict rules and regulations. For example, these organizations must engage in transparency with financial activities. They also have certain limitations on political involvement.

The most common way to receive tax-exempt status is to apply under Section 501(c)(3) of the Internal Revenue Code. If they qualify under this section, they enjoy exemptions from some federal, state, and local taxes. Donors can also write off their contributions on their individual tax returns.

Benefits of Tax-Exempt Status

The benefits of tax-exempt status for an organization are significant. To start, it exempts the organization from paying federal income taxes. This can result in significant savings. More funds can be used to be directed toward the organization's mission. Tax-exempt organizations may also be eligible for certain tax deductions that are not available for for-profit entities.

In addition, being recognized as a tax-exempt organization can enhance credibility and attract more donors. This is because contributions to charitable organizations are often tax-deductible for the taxpayer. This status also often results in lower postal rates and exemption from some state and local taxes, which further reduces the financial burden on the organization and allows it to maximize its impact.

Applying for Tax-Exempt Status With the IRS: Five Categories

To become tax-exempt, your organization must file Form 1023 or 1023-EZ with the IRS. The IRS looks at several categories to decide if you qualify. The IRS allows organizations to file for tax-exempt status under section 501(c)(3) if they fit within one of five identified categories. The organization must:

  • Have a charitable purpose, common for charitable organizations
  • Qualify as a religious group, meeting requirements for religious organizations
  • Be considered a scientific group
  • Serve a literary purpose
  • Qualify as an educational organization

The IRS defines these categories broadly but does not rubber-stamp all applications. For example, scientific organizations must perform research in the public interest, and educational organizations can not espouse a particular political viewpoint.

Keep in mind that there are numerous different types of exemptions under the tax code for different purposes, and your organization might find one more beneficial than the other. This can be especially true if your organization is involved in any type of lobbying or political work.

Before deciding to apply to become a 501(c)(3), it's a good idea to sit down and study other possibilities with your attorney. Together, you can decide on the type of exemption that best meets your needs.

State Tax Exemptions for Nonprofit Organizations

State tax exemptions for nonprofit organizations may depend on the IRS's decision on the group's federal application. Once the official notification of status arrives, the nonprofit should seek to confirm tax-exempt status in the state of residence. Generally, state tax-exempt status applies retroactively to the date of the federal grant.

Each state has its own tax laws. In New York, for example, nonprofits might not pay sales tax. To get this sales tax exemption, you would need to apply with your state's department, often the secretary of state's office. Remember, this is separate from your federal tax-exempt status. Your nonprofit might also get breaks on things like property tax and use tax, but this depends on your state's rules.

What To Do After Receiving Tax-Exempt Status

After receiving recognition of exemption, an organization should focus on effectively managing its operations and finances. This includes maintaining accurate records, filing annual returns with the IRS, and keeping the exemption certificate up to date. It's also important to register with local governments if required and to obtain any necessary permits or licenses.

In addition, connecting with your local chamber of commerce can provide valuable networking opportunities and additional information on running a successful nonprofit. Ensuring that all activities align with the organization's tax-exempt purpose is vital to avoid jeopardizing the status.

Keeping Your Tax-Exempt Status

Keeping your tax-exempt status requires diligent adherence to the rules set by the IRS. Once an organization achieves this status, it must continuously operate in alignment with its stated mission and abide by its articles of incorporation and bylaws. This involves ensuring its activities and financial transactions strictly serve its non-profit purposes. Regular reporting of gross receipts and other financial activities to the IRS is essential.

Failure to comply with these rules and regulations can result in the loss of tax-exempt status. This turns the organization into a taxable entity, so staying informed and up-to-date on relevant tax laws and changes is crucial for maintaining this privilege. To learn more about this topic, visit FindLaw's Keeping Your Nonprofit Tax Exempt Status page.

Nonprofit Organizations and Tax-Exempt Status: Get Legal Help

Nonprofit incorporation and federal tax exemption involve complex legal and taxation issues. For this reason, it's best to consult with an experienced tax attorney who can oversee the entire process and ensure that the organization meets all relevant statutory requirements.

If you are ready to start your nonprofit, consider our business formation services. We offer simple ways to set up your business quickly.

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