While often tedious, following the traditional tax filing process is necessary to stay compliant with the IRS. However, some organizations—namely nonprofits—can bypass this process by obtaining tax-exempt status.
If you run a new nonprofit or have not applied for tax exemption yet, this guide will help you get up to speed. We’ll cover what tax-exempt status entails, eligibility requirements, how to apply, and how to maintain your status so you can get started and reap the benefits as soon as possible.
What Tax-Exempt Status Entails
A nonprofit with tax-exempt status does not have to pay federal income taxes on revenue related to its charitable activities. The IRS is in charge of reviewing tax-exempt applications and granting tax-exempt status.
As a tax-exempt organization, your nonprofit can:
- Avoid paying federal income taxes
- Receive tax-deductible donations
- Unlock exclusive grant and funding opportunities
Ultimately, becoming a tax-exempt organization boosts credibility and allows you to funnel more resources toward your programming, empowering you to better fulfill your mission.
Eligibility Requirements
The IRS states that the following organization types can apply for tax-exempt status:
- Charitable organizations with exclusively religious, charitable, scientific, public safety, literary, educational, or other specified purposes
- Churches and religious organizations, including integrated auxiliaries and conventions or associations of churches
- Private foundations, which typically have one major funding source and primarily make grants to other charitable organizations and individuals
- Political organizations, which can be parties, committees, associations, funds, or other organizations with the purpose of accepting contributions or making expenditures for an exempt function
- Other nonprofits, like social welfare organizations, civic leagues, social clubs, labor organizations, and business leagues, which may qualify under subsections other than 501(c)(3)
In addition to falling under one of the above organization types, your organization must also adhere to the following to be eligible:
- Your organization must be a true nonprofit, meaning no earnings go to private shareholders or individuals.
- Your organization must not attempt to influence legislation as a substantial part of its activities or campaign for or against political candidates.
- Your organization’s activities must support its mission.
Public charities must also pass the public support test, which varies for different 501(c)(3) subcategories. Generally speaking, 509(a)(1) organizations must receive at least one-third of their support from the general public’s contributions, whereas 509(a)(2) organizations must receive more than one-third of their support from the general public’s contributions and/or gross receipts from activities related to their tax-exempt purposes.
If a 509(a)(1) organization receives between 10% and 33.3% of its support from the general public, it can still become tax-exempt by proving that it normally receives a substantial amount of its support from the government or the general public.
How to Apply for Tax-Exempt Status
To apply for tax-exempt status, you must complete Form 1023 or Form 1023-EZ, a streamlined version for smaller organizations. You may be eligible to fill out Form 1023-EZ if:
- Your annual gross receipts will not exceed $50,000 in any of the next three years.
- Your annual gross receipts have not exceeded $50,000 in any of the past three years.
- The fair market value of your total assets does not exceed $250,000.
You can review all the eligibility requirements for Form 1023-EZ and determine your eligibility using the Form 1023-EZ Eligibility Worksheet.
Then, gather the information you need to fill out the form. The standard Form 1023 requires information like:
- Your organization’s name
- Your organization’s employer identification number (EIN)
- A point of contact
- Your complete website address
- Any officers, directors, and trustees
- Organization type
- A copy of your organizing document with a purpose clause and dissolution clause
- Your organization’s formation date
- The state of formation
- Your organization’s bylaws
- A description of your activities
- Compensation you provide to any employees
Additionally, you will need to provide financial data by compiling and attaching the following documents:
- Statement of Financial Position. Form 1023 states that you must include a balance sheet for your most recently completed tax year, which is known in the nonprofit accounting world as a Statement of Financial Position. This document reports on your assets, liabilities, and net assets to determine your nonprofit’s liquidity and financial flexibility.
- Statement of Activities. The form also states that you must include a Statement of Revenue and Expenses, which is more commonly referred to as a Statement of Activities. Here, you’ll record your revenues and support, expenses, and the change in net assets to show how you manage your nonprofit’s resources.
Once you have submitted your application, the IRS will review it and notify you of its decision with a determination letter. The turnaround time for Form 1023-EZ is much shorter, with the IRS claiming to issue 80% of application determinations within 22 days and 80% of Form 1023 application determinations within 191 days.
In addition to the federal tax exemption, you may also apply for state and local tax exemptions. Use a resource like this chart from Harbor Compliance to determine your eligibility based on your state.
How to Maintain Tax-Exempt Status
Maintaining tax-exempt status involves continuing to meet the eligibility requirements, including using funds for mission-related purposes and following restrictions on political activities. Additionally, you will be required to do the following:
- File Form 990 each year. Form 990 is an annual tax form that nonprofits must file to confirm compliance with IRS regulations and maintain tax-exempt status. Since this form requires you to record your yearly revenue and expenses, it’s helpful to compile accurate nonprofit financial statements (like a Statement of Functional Expenses) to organize your financial data and simplify reporting.
- Make annual returns publicly available. After filing Form 990, you must make it publicly available. The IRS also requires you to make your exemption application public. In the name of transparency, many nonprofits will also make their financial statements public by including them in their annual reports or somewhere on their websites.
- Provide written acknowledgments to donors. Any donor who contributes a gift of $250 or more must receive a written acknowledgment of receipt to deduct the contribution from their taxes. Your acknowledgment should include your nonprofit’s name and EIN, the date of contribution receipt, the amount of a cash contribution or description of a non-cash contribution, and a statement that no goods or services were provided in return for the gift.
- Pay Unrelated Business Tax Income (UBIT). While your organization is exempt from paying taxes on income related to your mission, that does not exempt you from all taxes. If your nonprofit engages in a business activity unrelated to its mission, any income you generate from that activity is subject to UBIT. For instance, if your nonprofit sells merchandise to the public, the resulting funds will be taxed.
- Follow other IRS regulations and tax laws. Let’s say you work with an outside vendor or contractor and pay them more than $600 for their services. In this situation, you must file Form 1099. If you act as a contractor for another organization, then you must fill out a W-9, which provides the other organization with the information they need to file Form 1099. As YPTC’s W-9 for nonprofits guide explains, “While Form W-9 itself never reaches the IRS, it’s a stepping stone to accurate tax reporting. This form is necessary to prepare organizations to file Form 1099 and stay compliant with IRS regulations.”
Stay up to date with IRS requirements and filing deadlines by regularly visiting their website.
Obtaining and maintaining tax-exempt status allows your organization to maximize funding for its mission and serve its community to the best of its ability. If your team needs help compiling your financial data or staying compliant, reach out to a nonprofit accounting firm for assistance.
