Publication 557: Tax-Exempt Status for Your Organization

Gaining recognition as a tax-exempt organization from the Internal Revenue Service (IRS) is a formal process guided by IRS Publication 557, Tax-Exempt Status for Your Organization. This publication provides the framework for organizations seeking to be exempt from federal income tax under the Internal Revenue Code.

This article serves as a guide to the information within Publication 557. It breaks down the core concepts, from the various types of exempt organizations to the detailed application process and ongoing compliance duties required to maintain tax-exempt status.

Types of Tax-Exempt Organizations

The Internal Revenue Code provides for many types of tax-exempt organizations. The most widely recognized category is the 501(c)(3) organization, which is organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes. This category also includes organizations for fostering national or international amateur sports competition and for the prevention of cruelty to children or animals.

Within the 501(c)(3) classification, a distinction is made between public charities and private foundations. A public charity has a broad base of public support, receiving funding from the general public, government entities, or other public charities. Private foundations are controlled by a small number of donors and derive most of their support from limited sources. The IRS automatically presumes an organization is a private foundation unless it can demonstrate that it qualifies as a public charity.

While 501(c)(3) organizations are the most numerous, other classifications serve different functions. Section 501(c)(4) organizations are social welfare organizations that operate to promote the common good and general welfare of the community. They are permitted to engage in a greater degree of lobbying and some political campaign activities, which are forbidden for 501(c)(3)s.

Other specialized classifications include Section 501(c)(6), which applies to business leagues, chambers of commerce, and boards of trade devoted to improving business conditions. Another type is the 501(c)(7) organization, which covers social and recreation clubs organized for pleasure and other nonprofitable purposes for their members and guests.

Core Requirements for 501(c)(3) Status

To receive 501(c)(3) status, an organization must satisfy an organizational test based on its founding legal documents. These documents must limit the organization’s purposes to one or more of the exempt purposes listed in section 501(c)(3). The document cannot empower the organization to engage, other than as an insubstantial part of its activities, in activities that do not further its exempt purpose.

The organizational test also requires the inclusion of a dissolution clause. The articles of incorporation must dedicate the organization’s assets to an exempt purpose. This means that upon dissolution, any remaining assets must be distributed to another 501(c)(3) organization or to a federal, state, or local government for a public purpose.

Beyond the founding documents, an organization must meet the operational test, which examines its activities. The operational test requires that the organization engage primarily in activities that accomplish one or more of its stated exempt purposes. This test is ongoing and examines what the organization actually does, not just what its charter says it can do.

A part of the operational test is the prohibition against private benefit and inurement. No part of the net earnings of a 501(c)(3) organization may inure to the benefit of any private shareholder or individual, such as an officer or director. This prohibition extends to paying unreasonable compensation or engaging in transactions that benefit an insider at the organization’s expense.

Furthermore, 501(c)(3) organizations are forbidden from participating or intervening in any political campaign on behalf of any candidate for public office. While some lobbying activities are permitted, they must not constitute a substantial part of the organization’s overall activities. Organizations that anticipate significant lobbying can elect to have their lobbying expenditures measured by a specific dollar-based test under section 501(h).

Information and Documents Needed for the Application

Before applying, an organization must obtain an Employer Identification Number (EIN) from the IRS, even if it does not have employees. The EIN is a unique nine-digit number used for tax filing and reporting. Applying for an EIN can be completed online.

The application requires a conformed copy of the articles of incorporation, certified by the appropriate state authority, along with the organization’s bylaws. A comprehensive narrative describing the organization’s past, present, and planned future activities is also necessary. The IRS needs specifics about programs, events, and services to determine if operations align with the exempt purpose.

Financial data must also be provided. If the organization has been in existence, it must provide financial statements for the current year and the three preceding years. New organizations must provide a realistic projection of revenue and expenses for the next three years.

The application also requires a complete list of the organization’s officers, directors, and trustees, including their names, addresses, and any compensation. This information helps the IRS assess potential conflicts of interest.

The primary application form for 501(c)(3) status is Form 1023, Application for Recognition of Exemption. Certain small organizations may be eligible to file the streamlined Form 1023-EZ. Eligibility is limited to organizations with projected annual gross receipts of $50,000 or less and total assets of $250,000 or less. For other exempt organizations, such as those under section 501(c)(4), Form 1024 is the correct application.

The Application Process

Form 1023 and Form 1023-EZ must be filed electronically through the online portal Pay.gov. At the time of submission, a user fee must be paid. The fee for Form 1023 is $600, and the fee for Form 1023-EZ is $275, but applicants should check the IRS website for the most current schedule.

After the application is submitted, the IRS will send an acknowledgment letter. The application is then assigned to an IRS Exempt Organizations specialist for review, which can take several months. During the review, the agent may contact the organization by mail with a request for clarification or further documentation.

Responding to these inquiries promptly is necessary to keep the application process moving. Failure to respond can result in the application being closed without a determination.

The process culminates in the issuance of a determination letter from the IRS. A favorable determination letter is the official document that recognizes the organization’s tax-exempt status. The effective date of exemption is typically retroactive to the date of the organization’s formation if the application is filed within 27 months of formation.

Maintaining Tax-Exempt Status

To maintain its tax-exempt status, an organization must fulfill several ongoing compliance requirements, with the most important being the annual filing of an information return. Most tax-exempt organizations must file a version of Form 990, Return of Organization Exempt From Income Tax, each year. The specific form depends on the organization’s financial activity.

The thresholds for the Form 990 series are based on gross receipts and assets. Organizations with annual gross receipts of $50,000 or less can file Form 990-N, an online notice. Those with gross receipts under $200,000 and total assets under $500,000 may file Form 990-EZ, while organizations exceeding these thresholds must file the more comprehensive Form 990. Failure to file for three consecutive years results in the automatic revocation of tax-exempt status.

Exempt organizations must also be mindful of unrelated business income (UBI). UBI is income from a trade or business that is regularly carried on and is not substantially related to the organization’s exempt purpose. If an organization has $1,000 or more of gross income from an unrelated business, it must file Form 990-T, Exempt Organization Business Income Tax Return, and pay tax on that income.

An exempt organization must keep detailed financial and non-financial records to justify its ongoing qualification for exemption. This includes books of account, records of revenue and expenses, documentation of program activities, and minutes of board meetings. These records are essential for accurately preparing the annual Form 990.

Tax-exempt organizations are also subject to public disclosure rules. An organization must make its approved application for exemption and its annual information returns available for public inspection upon request. Finally, an organization must report any material changes in its operations or structure to the IRS, such as a change of name or address.