What Tax Benefits Do Nonprofits Receive?

A nonprofit organization is structured around a mission to serve the public good rather than to generate private profit. These entities operate for charitable, educational, religious, scientific, or literary purposes, directing any surplus revenues back into their operations. In recognition of their contributions, federal, state, and local governments provide a beneficial tax structure that supports their missions by freeing up financial resources.

Federal Income Tax Exemption

The primary tax benefit for a qualifying nonprofit is exemption from federal income tax, a status defined under Section 501(c)(3) of the Internal Revenue Code. This exemption applies to income generated from activities substantially related to the organization’s exempt purpose. To receive this benefit, an organization must apply to the Internal Revenue Service (IRS) by filing Form 1023 or the streamlined Form 1023-EZ.

While there are many classifications of tax-exempt organizations, 501(c)(3) status is the most common. This category includes entities organized for purposes that are charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, or preventing cruelty to children or animals. The IRS requires that the organization’s founding documents, such as its articles of incorporation, contain specific language dedicating its assets to these exempt purposes.

Related income is revenue generated from activities directly linked to the nonprofit’s mission. For instance, a historical museum’s revenue from admission fees and the sale of educational materials in its gift shop is considered related income and is exempt from federal income tax.

The process of obtaining this exemption requires a user fee and must be completed within 27 months of the organization’s formation to be effective from the date of its creation. The IRS carefully reviews the application to confirm that the organization’s purpose and planned activities align with the requirements of Section 501(c)(3). Approval from the IRS results in a determination letter that formally recognizes the organization’s tax-exempt status.

State and Local Tax Exemptions

Beyond the federal level, nonprofits often qualify for tax relief from state and local governments, though these benefits are not automatic. After securing federal 501(c)(3) status, an organization must separately apply to the relevant state and municipal authorities. The specific requirements and the extent of the benefits can vary considerably from one jurisdiction to another, requiring organizations to research the rules where they operate.

A primary state-level benefit is an exemption from corporate income tax, which most states grant to organizations recognized as tax-exempt by the IRS. The application process involves submitting a copy of the IRS determination letter along with a state-specific form to the state’s department of revenue.

An exemption from local property taxes is another benefit. For nonprofits that own real estate, such as a building for their headquarters, a community center, or land for conservation, this exemption can result in substantial annual savings. The property must be used for purposes that are directly related to the organization’s exempt mission, which prevents holding commercial property tax-free if it is not used for a charitable purpose.

Many states also provide an exemption from sales and use tax. This allows a nonprofit to purchase goods and services for its operations—such as office supplies, equipment, and utilities—without paying sales tax. In some jurisdictions, this benefit extends to an exemption from collecting sales tax on items the nonprofit sells, provided those sales are related to its exempt function.

Facilitating Tax-Deductible Donations

An advantage of 501(c)(3) status is the ability to attract financial support by offering donors a tax deduction for their contributions. This incentive allows individuals and corporations to reduce their own taxable income by donating to a qualified organization. Only donations to organizations with this status are eligible for such tax treatment.

For any single contribution of $250 or more, the organization must provide the donor with a written acknowledgment. This donation receipt must include:

• The name of the organization
• The amount of any cash contribution
• A description (but not a value) of any non-cash contribution
• A statement on whether the organization provided any goods or services in consideration for the contribution

A “quid pro quo” contribution occurs when a donor receives a benefit in return for their donation, such as tickets to a fundraising gala. In these cases, the nonprofit must provide a written disclosure statement informing the donor of the fair market value of the benefits. The donor’s tax deduction is then limited to the amount of their contribution that exceeds the value of the benefit received. Properly managing this process supports donors in claiming deductions and upholds the integrity of the nonprofit’s fundraising practices.

Obligations and Taxable Activities

The term “tax-exempt” can be misleading, as nonprofits are responsible for certain taxes. They can be liable for income tax on revenue generated from activities that fall outside their primary mission, which ensures they do not have an unfair competitive advantage over for-profit businesses.

A significant tax liability for a nonprofit is the Unrelated Business Income Tax (UBIT). This tax applies to income from a trade or business that is regularly carried on and is not substantially related to the organization’s exempt purpose. For an activity to be considered an unrelated business, it must meet all three of these criteria. For example, if a university-run museum operates a public parking lot that serves patrons of a nearby professional sports stadium, the income from that lot would likely be subject to UBIT because it is not substantially related to the university’s educational mission.

The first $1,000 of net income from an unrelated business is exempt from UBIT due to a specific deduction, but any income above this threshold is taxed at corporate rates. Nonprofits with unrelated business income must file Form 990-T, Exempt Organization Business Income Tax Return, to report this income and pay any tax due.

Beyond UBIT, nonprofits with employees have the same payroll tax responsibilities as other employers. They must withhold federal and state income taxes from employee wages and pay their share of Social Security and Medicare taxes under the Federal Insurance Contributions Act (FICA). Additionally, nonprofits are required to pay federal and state unemployment taxes to provide benefits for former employees.

Key Compliance for Maintaining Benefits

Tax-exempt status must be actively maintained through ongoing compliance with specific rules and regulations. Failure to meet these obligations can result in penalties or even the revocation of tax-exempt status.

Most tax-exempt organizations must file an annual information return with the IRS, such as the Form 990, Form 990-EZ, or Form 990-N. Unlike a tax return, the Form 990 is a transparency document made available to the public. This allows donors, researchers, and government agencies to review the organization’s operations and ensure it is adhering to its mission.

A rule for 501(c)(3) organizations is the prohibition on private inurement. This principle dictates that none of the organization’s net earnings may inure to the benefit of any private shareholder or individual. The organization cannot allow its income or assets to excessively benefit an insider, such as a director, officer, or key employee. Transactions with insiders must be conducted at fair market value, and compensation must be reasonable for the services provided.

Finally, 501(c)(3) organizations are prohibited from participating or intervening in any political campaign for or against a candidate for public office. While some lobbying is permitted, it cannot constitute a substantial part of the organization’s overall activities. These rules ensure that tax-deductible contributions are not used to subsidize partisan political activities.