In other words, a nonprofit organization is not required to pay federal income taxes.
More in depth, a 501c3 is a nonprofit corporation considered by the IRS to be either a “public charity” or a “private foundation” under section 501(c)(3) of the Internal Revenue Code. Upon filing the required documents and receiving IRS tax-exempt status, such an organization is tax-exempt, meaning that it is not required to pay taxes on donations made to it, or even on certain forms of income made by the organization.
501c3 organizations are split into two categories: public charities and private foundations. Public charities are much more common – and generally more desirable – so we’ll start with those and address private foundations in a moment.
How hard is it to obtain 501c3 approval? And how long does it take to register as a 501c3 organization?
Unfortunately, obtaining 501c3 approval is a very long and involved process beginning with filing articles of incorporation with your state, drafting and enacting bylaws, forming a board of directors, selecting the nonprofit officers, enacting a conflict of interest policy, completing the IRS 501c3 application, including a projection of your financial data for the nonprofit’s first three years, and much more.
However, with the help of Harvard trained lawyer David G Marmon and his 37+ years of experience doing just that, turning your charitable dreams into a registered 501c3 will be an easy step by step process.
The earlier you start, the better! The IRS processing times for 501c3 applications are notoriously long, ranging from 3-10 months, with an average of 3-9 months. And making a mistake as a result of trying to do it yourself can cost you months more in delays as the IRS sorts out the information they need or just denies tax-exempt status to your organization.
The good news is, once you receive that 501c3 approval letter from the IRS, your tax-exempt status is retroactive to the date of your application (sometimes earlier), meaning any contributions received since then are tax-exempt for you, and tax-deductible for the donors.
Obtaining 501c3 tax-exempt status is one of the best actions you can take for your charitable organization. Not only will donations to the nonprofit be tax-exempt, but they will also be tax-deductible for the donors, meaning donors will be significantly more motivated to give to your charity.
Moreover, income from business sources related to the organization’s tax-exempt purpose is also tax-exempt. For example, an organization could teach homeless individuals how to paint, and later could sell their paintings to others. The income from selling the paintings would be directly related to the exempt purpose of the organization–rehabilitating homeless individuals through painting workshops–and so would not be taxed income. Note that unrelated business income, such as this organization also running a for-profit art gallery (separate from their selling of the paintings by the homeless individuals), is generally taxed if grossing more than $1,000 annually.
Registered 501c3 organizations are also perceived as more credible by potential donors. Donors, especially those with large donations to make, want to be sure that their money will be used wisely and effectively to support the cause toward which they are donating. Registering as a 501c3 indicates that your charitable work has been approved of by an impartial governmental agency (the Internal Revenue Service), and that you have taken certain required steps such as establishing a board of unrelated directors.
In addition, grant-making foundations will usually refuse to make a grant to an organization that is not a registered 501c3. Because these situations frequently involve large sources of funding for nonprofits, it is very beneficial to obtain your 501c3 status early.
Are there any negatives to being a registered 501c3? Tax-exempt organizations do face compliance-related required filings every year, as well as the responsibility to maintain records such as receipts and records of contributions received. Moreover, 501c3 organizations cannot generally engage in political activity, and officers and directors are limited to reasonable salaries.
These considerations, however, amount to basic principles of bookkeeping, and of charitable work. Thus, if your goal is to make a political impact or to make a personal profit, a public charity may not be for you. Otherwise, public charities are the perfect vehicle for turning your charitable dreams into a reality that will be well-respected and well-funded.
Let’s take a look at 501c3 compliance issues.
501c3 compliance is relatively basic, but extremely important. Many organizations, as discussed further below, are only required to file a very simple electronic form. However, even for these organizations, the consequences of failing to file are great: any organization required to file an annual return and failing to do so for three consecutive years will be subject to losing their tax-exempt status entirely. This results in a long and expensive process to regain 501c3 status.
Annual Exempt Organization filings for 501c3 organizations. All tax-exempt organizations (with the exception of churches and certain church-affiliated organizations) must file an annual return with the IRS. This keeps the IRS informed on the activities and financial status of the nonprofit, and helps them ensure that tax-exempt organizations remain charitable in nature, rather than slowly morphing into tax-exempt for-profit businesses.
Most organizations will use Form 990 or a variant for this purpose. Small organizations, defined by the IRS as “those whose gross receipts are normally $50,000 or less,” are permitted to file a very simple online form. Larger organizations, however, will be required to submit more detailed information.
501c3 organizations with more than $1,000 in unrelated business income will also need to file Form 990-T and pay taxes on this income. Moreover, all organizations with paid employees will need to file the appropriate forms to pay their employee taxes.
Let’s look at private foundations for a moment.
How does a private foundation 501c3 differ from a public charity 501c3? A private foundation is the broader, typically less desirable, cousin of the public charity. In fact, all 501c3 organizations are initially assumed by the IRS to be private foundations, unless they prove that they meet the requirements to be upgraded to public charity status.
A private foundation is, most commonly, an organization established to take one principal source of funding and use it to advance a particular purpose by making grants to public charities that support that purpose.
Primarily, private foundations do not carry out the charitable activities themselves, but act through making grants to other 501c3 organizations, especially public charities. A typical example of a private foundation would be a family setting up a private foundation to handle one million dollars and use it to make grants to public charities established for the prevention of animal cruelty.
One benefit of a private foundation is that the board of directors can be composed entirely of family members, whereas public charities must have a majority of unrelated members. In the above example, this would allow the funding family to maintain control over the use of their funds, rather than using a public charity, where they give over control to those running the charity.
For this reason, some organizations prefer to remain a private foundation, an action that is permitted by the IRS even in cases where the organization operates as if it were a public charity. However, this comes with a few disadvantages…
Private foundations are prone to misuse, largely because they can easily be used for self-profiting tax evasion and investment strategies. For this reason, the IRS has developed a set of detailed rules to govern these foundations, and to make certain requirements it believes will keep their operations in check.
Private foundations are required to donate a set percentage of the fair market value of their investment assets each year – generally 5%. If they fail to do so, a penalty tax will be imposed. Moreover, private foundation 501c3 organizations are taxed 1-2% on the interest from their investment assets each year.
There are also penalty taxes imposed on several other transactions, such as self-dealing transactions, certain taxable expenditures, investments which jeopardize their charitable purposes, and taxes on certain stock holdings.
Otherwise, private foundations are very similar to public charities. Donations made to them are tax-deductible, and contributions received by them are tax-exempt.
Note that there is a final type of organization called a “private operating foundation.” This is a hybrid of private foundations and public charities. A private operating foundation uses at least 85% of its adjusted net income or minimum investment return for the operation of its own charitable activities. A typical example would be a museum or preservation of a historical farm, or any organization operating as a public charity but wanting to maintain family control and so remaining a private operating foundation.
A private operating foundation may seem like the best of both worlds, but it is important to remember that it comes with significantly higher regulations and the requirement that financial tests be met each year to prove it is not functioning merely as a private (non-operating) foundation (In addition to the 85% test mentioned above, a private operating foundation must meet one of three other tests each year, essentially requiring that either 65% of its assets be directly devoted to exempt purposes, or 67% of its minimum investment returns be donated directly to exempt purposes, or “substantially all of its support” be received from the general public and five or more exempt organizations that are not private foundations).
It is generally easier for a private operating foundation to obtain outside funding, especially because private foundations can satisfy their annual donation requirements discussed above by making grants to other 501c3 organizations, including to private operating foundations. Note that private operating foundations do not have this annual donation requirement – instead they must meet the tests described above.
For organizations that want to be controlled by one family, and/or funded primarily by one source, that want to carry on their own work, and that will also be seeking funding from the public and from other 501c3’s, the private operating foundation may be a good idea. For those who will be controlled and/or funded by one primary source and would prefer making donations to other 501c3’s over actually performing tax-exempt activities, the private foundation will suit their interests better.
So, what is a 501c3? It’s the perfect way to ensure all your funds and energy are directed into your charity rather than going through the tax and hassle of doing the same work without the 501c3 tax-exempt structure.
501c3 status will give you tax exempt contributions, make donations tax-deductible, give you credibility and eligibility for grants, and help generate more enthusiasm in donors for the charitable work you’re already doing.
Start fulfilling your dream now, fill out our online form to get the process started.