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What Are the Benefits and Drawbacks of Nonprofit Tax-Exempt Status?

Nonprofit organizations play a vital role in our society. They help reach millions of people every year throughout the world through good works and deed. Think of organizations such as Human Rights Watch (HRW), United Nations Children's Fund (UNICEF), and the Sierra Club. While you might be considering turning your passion into a reality by becoming a nonprofit, you'll want to understand the laws and regulations surrounding this area.

Many organizations see only the financial benefits of nonprofit and tax-exempt status. Qualifying groups pay no tax on federal, state, and local taxes, and therefore can devote a larger proportion of their resources to achieving their particular goals. The status can also qualify groups for special grants or government funding, as well as special rates for services or even postage. Donors prefer contributions to these groups because they can deduct the payments from their own taxes.

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Becoming Tax-Exempt: Section 501(c)(3) of the Internal Revenue Code

In order to gain tax-exempt status, you'll need to dive into the ever-intimidating United States Tax Code through the Internal Revenue Service (IRS). In order qualify for special tax-exempt status under 501 (c)(3), your nonprofit's key purpose has to fall into one of five categories reserved for charitable organizations. These include an organization that has a "Charitable Purpose," is a "Religious Group," is a "Scientific Organization," serves a "Literary Purpose," or qualifies as an "Educational Organization."

The Corporate Shield

The form of the organization offers advantages in itself. Since nonprofits exist as corporations, they possess all the benefits of corporate status. The corporate form shields owners and managers of the organization from personal liability for the group's actions, subject to certain legal exceptions. Nonprofit incorporation formalizes the group's goals and helps maintain organizational focus as the effort grows.

Keep in mind, one of the best ways to maintain your corporate protection is to always document the major business decisions and nonprofit meetings you hold. Major business decisions include any contracts your nonprofit enters into, meeting minutes for all annual meetings of directors and shareholders (corporations) or members/managers. It is a wise idea to always keep these records in either a electronic or paper format for 7-10 years in case you are ever sued or audited.


Despite these advantages, nonprofit and tax-exempt status should not be an automatic goal. Drawbacks to the status include:

  • inability to divide profits among members beyond payment of reasonable salaries;
  • limitations on the sources of the group's incomes; and restrictions on the use of assets to purposes justifying tax exemption.

Some organizations prefer the flexibility and potential for personal gain implicated by forprofit status. Other organizations eschew incorporation entirely. Many smaller organizations will not realize substantial advantages from nonprofit tax-exempt status after going through the intensive application process. Each individual group must weigh the pros and cons of the status carefully in light of their organizational goals and values.

Additional Resources

An Attorney Can Help with Your Nonprofit Questions

As you're considering the tax benefits of forming a nonprofit, you'll want to also understand the legal responsibilities that come with this designation. Arming yourself with more information is a key step in nonprofit formation, and the best way to do that is to contact a skilled tax attorney in your area.

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