Do Nonprofits Pay Taxes? A Breakdown of Tax Liabilities

Nonprofit organizations are often perceived as entirely tax-exempt due to their public benefit missions. While they do enjoy significant tax advantages, the reality is more complex than a blanket exemption. Nonprofits are exempt from certain taxes, primarily federal income tax on activities related to their charitable purpose. However, they remain liable for various other taxes, similar to for-profit entities, depending on their operations and specific circumstances. This nuanced tax landscape requires careful understanding to ensure compliance and maintain their special status.

Understanding Tax-Exempt Status

Tax-exempt status signifies that an organization is not subject to federal income tax on income generated from activities substantially related to its exempt purpose. This status is not automatically granted; organizations must formally apply to the Internal Revenue Service (IRS) to obtain this recognition. The most common designation is under Internal Revenue Code Section 501(c)(3), reserved for organizations operating for religious, charitable, educational, scientific, or similar purposes.

To qualify for 501(c)(3) status, an organization must satisfy both an organizational test and an operational test. The organizational test requires founding documents to limit purposes to exempt activities and dedicate assets permanently to those purposes, including upon dissolution. The operational test mandates that the organization primarily engage in activities that further its exempt purposes, with no more than an insubstantial part of its activities being non-exempt. Additionally, no part of the organization’s net earnings may benefit any private shareholder or individual, a concept known as private inurement.

The process of applying for this status involves submitting Form 1023 to the IRS. This comprehensive form requires detailed information about the organization’s structure, governance, activities, and financial data. Smaller organizations with gross receipts not exceeding $50,000 annually and total assets under $250,000 may file the streamlined Form 1023-EZ.

Taxes Nonprofits Typically Do Not Pay

The primary benefit of achieving tax-exempt status is exemption from federal income tax on income derived from activities directly related to the organization’s stated exempt purpose. This means that donations, program service fees, and other revenues that support the charitable, educational, or religious mission are not subject to federal income taxation. This exemption is a financial advantage, allowing nonprofits to reinvest more funds into their programs and services.

Beyond federal income tax, many states also offer similar income tax exemptions for organizations recognized as tax-exempt by the IRS. The specifics of these state-level exemptions can vary, but they mirror the federal provisions for income directly tied to the organization’s mission. While these exemptions are broad, they apply specifically to income generated from activities aligned with the nonprofit’s exempt purpose.

Taxes Nonprofits May Pay

Despite their tax-exempt status, nonprofits are responsible for several types of taxes, similar to those paid by for-profit businesses. Understanding these obligations is important for proper financial management and compliance.

Nonprofits with employees are required to pay payroll taxes. This includes withholding federal income tax from employee wages and remitting it to the IRS. Nonprofits must also withhold and match Social Security and Medicare taxes (FICA taxes), which are split between the employer and employee. Federal Unemployment Tax Act (FUTA) taxes are an employer responsibility, though some 501(c)(3) organizations may be exempt. Many states also impose state unemployment taxes (SUTA), for which nonprofits are liable.

Nonprofits are not universally exempt from sales taxes. While some states and local jurisdictions provide exemptions for nonprofits from either collecting sales tax on their sales or paying sales tax on their purchases, rules differ significantly by jurisdiction. An organization’s eligibility for sales tax exemption depends on the specific nature of the transaction and the local tax laws. Nonprofits must consult the relevant state and local tax authorities to determine their sales tax obligations and exemptions.

Property taxes, levied by local governments, are not automatically waived for nonprofits. Exemption from property taxes depends on state and local laws, which require the property to be used directly for the organization’s exempt purpose. For instance, a building used for charitable programs might be exempt, while a rental property owned by the nonprofit might not be. These exemptions are applied for at the local level and are subject to specific usage criteria.

The Unrelated Business Income Tax (UBIT) is a tax liability for some nonprofits. This tax applies to income generated from a trade or business that is regularly carried on and is not substantially related to the organization’s exempt purpose. The purpose of UBIT is to prevent tax-exempt organizations from having an unfair competitive advantage over for-profit businesses that engage in similar commercial activities. Examples of activities that could generate UBIT include operating a commercial parking lot, selling advertising in a publication, or running a gift shop that sells items unrelated to the organization’s mission. Income determined to be unrelated business income is taxed at standard corporate income tax rates.

Compliance and Maintaining Status

Maintaining tax-exempt status requires ongoing adherence to IRS regulations and specific filing requirements. Most tax-exempt organizations are obligated to file an annual information return with the IRS, using one of the Form 990 series. The specific form depends on the organization’s gross receipts and assets.

Smaller organizations with gross receipts $50,000 or less file Form 990-N (e-Postcard). Organizations with gross receipts less than $200,000 and total assets less than $500,000 may file Form 990-EZ. Larger organizations with gross receipts of $200,000 or more, or assets of $500,000 or more, must file Form 990. These forms provide the IRS and the public with financial information and operational details of the organization, ensuring transparency.

Certain activities can jeopardize a nonprofit’s tax-exempt status. Prohibited activities include excessive lobbying (attempting to influence legislation as a substantial part of activities). Direct or indirect participation in any political campaign is absolutely prohibited. Private inurement, where an insider benefits inappropriately from the organization’s net earnings, can lead to penalties.

Failure to comply with IRS regulations, including failing to file annual information returns for three consecutive years, can result in the automatic revocation of tax-exempt status. Revocation means the organization loses its federal income tax exemption and may then be subject to federal income tax on all its income, not just unrelated business income. This can also lead to the loss of state tax exemptions and the ability for donors to claim tax deductions for their contributions, significantly impacting the organization’s financial viability.