Exempt Organizations: Requirements and Types
Gain insight into the federal requirements that govern tax-exempt organizations, from their legal formation to their ongoing operational responsibilities.
An exempt organization is an entity not subject to federal income tax because it is organized for specific non-profit purposes. The Internal Revenue Service (IRS) grants this status, which requires that an organization’s activities serve a public or mutual interest rather than the private interest of any individual. An organization that qualifies for federal exemption is not automatically exempt from state or local taxes, which have their own distinct requirements. Obtaining and maintaining this status involves a detailed application and ongoing compliance.
Categories of Federal Tax-Exempt Status
The Internal Revenue Code (IRC) provides for many types of tax-exempt organizations, primarily under Section 501(c). The classification determines an organization’s allowed activities, its eligibility to receive tax-deductible contributions, and its operational limitations.
The most common classification is the 501(c)(3) organization, which is operated for religious, charitable, scientific, literary, or educational purposes. This category also includes organizations that foster amateur sports competition or prevent cruelty to children or animals. Contributions made to these organizations are tax-deductible for the donor under IRC Section 170, making this status desirable for groups that rely on donations.
Within the 501(c)(3) classification, the IRS distinguishes between public charities and private foundations. A public charity has a broad base of public support, receiving a significant portion of its revenue from the general public or government grants. To maintain this status, an organization must receive at least one-third of its support from small-dollar donors, other public charities, and government sources.
Private foundations, in contrast, are often funded by a small number of sources, such as a single family or corporation. They primarily issue grants to other organizations rather than operating their own direct charitable programs. Because they are less subject to public scrutiny, private foundations face stricter operating rules and regulations.
Another category is the 501(c)(4) organization, which includes social welfare organizations and local associations of employees. These entities must operate to promote the common good and general welfare of the community. Unlike 501(c)(3) organizations, 501(c)(4)s can engage in some political activities that support their social welfare mission, though contributions to them are not tax-deductible.
Business leagues, chambers of commerce, and real estate boards are classified as 501(c)(6) organizations, which promote the common business interests of their members. Social and recreational clubs, such as country clubs, are classified as 501(c)(7) organizations and must be funded primarily by membership fees. Other specialized classifications exist for groups like labor unions under 501(c)(5) and veterans’ organizations under 501(c)(19).
Required Documentation for Federal Application
Before an organization can receive federal tax-exempt status, it must assemble a package of documents for the IRS. The first requirement is obtaining an Employer Identification Number (EIN) by filing Form SS-4. The EIN is a unique number that identifies the business entity for tax purposes and is necessary before applying for an exemption.
Other required documents include:
- Organizing Document: This is the legal instrument that creates the entity, such as articles of incorporation or a trust agreement. It must limit the organization’s purposes to those specified in the relevant 501(c) section. For 501(c)(3) applicants, it must also include a clause ensuring that upon dissolution, assets are distributed for an exempt purpose.
- Bylaws: These are the internal operating rules that detail procedures for governance, such as electing directors and holding meetings.
- Narrative of Activities: A thorough description of the organization’s past, present, and planned future activities is required to show how its operations align with its exempt purpose.
- Financial Information: An organization must submit statements of revenue and expenses and a balance sheet. New organizations must provide realistic projected financial data for the next few years, while existing organizations must provide data for prior years.
This information is used to complete the primary application, such as Form 1023 for 501(c)(3) organizations or Form 1024-A for 501(c)(4)s. Other groups, like business leagues, use Form 1024. A streamlined version, Form 1023-EZ, may be an option for smaller 501(c)(3) applicants projecting annual gross receipts of $50,000 or less and having assets under $250,000.
The Federal Application Process
All applications for tax-exempt status must be filed electronically through the federal government’s online portal, Pay.gov. This requires the applicant to create an account on the website to access and complete the relevant form.
All supporting documents, including the organizing document, bylaws, and financial statements, must be combined into a single PDF file. This file is then uploaded as an attachment to the electronic application.
A non-refundable user fee must be paid at the time of submission. The amount varies; for example, the fee for Form 1023 has recently been $600, while the fee for Form 1023-EZ has been $275. Applicants should verify the current fee on the IRS website, as payment is made directly through the Pay.gov portal.
After submission, the IRS may review the application and request additional information. The timeline for a final decision can range from a few months to over a year, depending on the application’s complexity. The process concludes when the IRS issues a determination letter that either grants or denies tax-exempt status.
Annual Compliance and Filing Obligations
Maintaining tax-exempt status requires ongoing compliance with IRS regulations, including the annual filing of an information return. Most exempt organizations must file a form from the Form 990 series each year. The specific form required depends on the organization’s financial thresholds.
Organizations with annual gross receipts normally $50,000 or less can submit Form 990-N, an electronic notice confirming operation. Mid-sized organizations, with gross receipts under $200,000 and assets under $500,000, file Form 990-EZ. Larger organizations must file the comprehensive Form 990.
Private foundations have their own specific return, Form 990-PF, which they must file regardless of their financial size.
An organization that fails to file its required return for three consecutive years will automatically have its tax-exempt status revoked. The due date for the return is the 15th day of the 5th month after the end of the organization’s accounting period. For an organization using the calendar year, the deadline is May 15th.
Exempt organizations must also adhere to public disclosure requirements. An organization must make its approved application and its annual information returns for the past three years available for public inspection upon request. These documents are also made publicly available by the IRS.
Maintaining status also requires adherence to operational rules. For 501(c)(3) organizations, the organization’s net earnings cannot benefit any private individual, particularly an insider. These organizations are also forbidden from participating in any political campaign on behalf of or in opposition to any candidate for public office, and their lobbying activities are subject to limits.
Understanding Unrelated Business Income Tax
An exempt organization can be liable for income tax on revenue from activities not related to its primary mission. This is known as Unrelated Business Income (UBI), and the tax is the Unrelated Business Income Tax (UBIT). Any exempt organization with at least $1,000 in gross income from an unrelated business must file Form 990-T and pay the tax.
The IRS uses a three-part test to determine if an activity generates UBI. First, the activity must be a trade or business, defined as any activity carried on to produce income from selling goods or services. Second, the business must be regularly carried on, meaning it is conducted with a frequency similar to comparable commercial activities.
The third part of the test is that the activity must not be substantially related to the organization’s exempt purpose. A causal relationship must exist between the business activity and the mission. The activity itself must contribute importantly to accomplishing the organization’s purpose, aside from simply providing funds.
For example, a university bookstore that sells textbooks to students is conducting a related activity, so the income is not UBI. If that same university operated a car manufacturing plant, the income would be unrelated and subject to UBIT. Similarly, a museum gift shop that sells reproductions of art from its collection is carrying on a related activity.
Income subject to UBIT is taxed at corporate tax rates. This ensures that non-profit organizations do not have an unfair competitive advantage over commercial enterprises when they engage in similar business activities. The requirement to pay UBIT underscores that tax exemption is tied to an organization’s purpose.