Do Not-for-Profit Organizations Pay Taxes?

The question of whether not-for-profit organizations pay taxes is more complex than a simple yes or no. A nonprofit is an entity structured to pursue a public or mutual benefit rather than generating profit. While many nonprofits are exempt from federal income tax, this exemption is not absolute. Many organizations are still liable for certain federal, state, and local taxes, depending on their activities and the specific regulations governing them.

Achieving Federal Tax-Exempt Status

Tax exemption is a privilege granted by the Internal Revenue Service (IRS), not an automatic right. To qualify, an entity must first be established according to state law, typically as a trust, corporation, or association. The organization’s founding documents must pass the “organizational test,” which requires the documents to limit the organization’s purposes to one or more exempt activities, such as charitable, religious, or educational missions as defined under Internal Revenue Code (IRC) Section 501(c)(3).

The organization must also satisfy the “operational test,” meaning it must primarily engage in activities that directly accomplish its stated exempt purpose. For example, a nonprofit food bank must spend its resources distributing food to those in need. Any deviation from this core operational focus can jeopardize its eligibility for tax-exempt status.

The formal process of seeking this status involves filing Form 1023, Application for Recognition of Exemption. This application requires a comprehensive narrative of the organization’s activities, financial projections, and detailed information about its governance structure, including its officers and directors. The IRS user fee for filing Form 1023 is $600, though smaller organizations eligible to file the streamlined Form 1023-EZ pay $275. The review process can take several months, after which the IRS may issue a determination letter that officially recognizes the organization’s tax-exempt status.

The Scope of Federal Income Tax Exemption

Once an organization achieves tax-exempt status under a provision like Section 501(c)(3), it is relieved from paying federal income tax on revenue generated from activities that are substantially related to its core mission. This exemption allows it to reinvest funds into its programs rather than paying taxes. The determinant is the direct connection between the revenue-generating activity and the organization’s exempt purpose.

For example, a university, whose exempt purpose is education, does not pay federal income tax on tuition fees or revenue from its campus bookstore when it sells textbooks. Similarly, a museum’s income from admission charges and membership fees is considered related to its educational and cultural mission and is therefore exempt. Donations received by a church to support its religious activities are another clear example of exempt income.

Unrelated Business Income Tax

The most instance where a nonprofit pays federal income tax is on its Unrelated Business Income (UBI). This is income generated from activities that do not directly align with the organization’s exempt purpose. The IRS applies a three-part test to determine if income is taxable as UBI: the activity must be a trade or business, be regularly carried on, and be not substantially related to the organization’s exempt mission.

The first criterion, “trade or business,” refers to any activity conducted for the production of income. The second, “regularly carried on,” means the activity is pursued with a frequency similar to comparable commercial ventures. For instance, a nonprofit operating a public cafeteria every day would meet this standard, whereas a one-time bake sale would not.

The final criterion is whether the activity is “substantially related” to the organization’s exempt purpose. A university bookstore selling textbooks is related to its educational mission, but if that same store sells computers to the general public, that portion of its income would likely be considered unrelated. The sale of advertising space in a nonprofit’s journal is also generally considered UBI.

When a nonprofit has UBI, it must file Form 990-T, Exempt Organization Business Income Tax Return. The net earnings from these unrelated activities are taxed at the flat 21% corporate tax rate for corporations, or at the separate, progressive tax rates for trusts. This ensures that nonprofits do not have an unfair competitive advantage over for-profit enterprises.

Other Federal, State, and Local Tax Obligations

Beyond federal income tax, not-for-profit organizations face several other tax liabilities. If a nonprofit has employees, it is responsible for federal employment taxes, just like any for-profit entity. This includes withholding federal income taxes from employee paychecks and paying the employer’s share of Social Security and Medicare taxes (FICA). Nonprofits must also pay federal unemployment taxes (FUTA).

Achieving federal tax-exempt status does not automatically grant exemption from state and local taxes. Each state has its own application process and requirements for exemption from state corporate income tax, which must be completed separately.

Property and sales taxes are two other areas of state and local tax obligations. Many nonprofits own real estate, but property tax exemption is not guaranteed and requires an application with the local tax assessor’s office. Similarly, while some states provide sales tax exemptions for purchases made by nonprofits, if a nonprofit sells goods or services, it may be required to collect sales tax from customers and remit it to the state.

Annual Filing and Public Disclosure Requirements

Most tax-exempt organizations are required to file an annual information return with the IRS. This filing, commonly the Form 990, is a detailed report on the organization’s finances, governance, and activities. Its purpose is to provide transparency and ensure the organization continues to operate in a manner consistent with its tax-exempt status. The specific version of the form a nonprofit must file depends on its gross receipts and total assets.

Organizations with gross receipts greater than $200,000 or assets of $500,000 or more file the standard Form 990. Smaller organizations, with gross receipts under $200,000 and assets under $500,000, may file the simpler Form 990-EZ. The smallest nonprofits, those with gross receipts of $50,000 or less, can satisfy their annual filing requirement by submitting Form 990-N, an electronic notice.

A key aspect of this requirement is public disclosure. An organization’s filed Form 990 is a public document. The IRS makes these returns available for public inspection, and organizations are required to provide copies to anyone who requests them. This transparency allows donors, researchers, and government agencies to scrutinize a nonprofit’s operations and finances.