Tax Exempt Organizations: Formation, Income Tax Return

A 501(c) organization is a nonprofit organization in the federal law of the United States according to Internal Revenue Code Section 501(c) (26 U.S.C. § 501(c)) and is one of over 29 types of nonprofit organizations exempt from some federal income taxes. Sections 503 through 505 set out the requirements for obtaining such exemptions. Many states refer to Section 501(c) for definitions of organizations exempt from state taxation as well. 501(c) organizations can receive unlimited contributions from individuals, corporations, and unions.

For example, a nonprofit organization may be tax-exempt under section 501(c)(3) if its primary activities are charitable, religious, educational, scientific, literary, testing for public safety, fostering amateur sports competition, preventing cruelty to children, or preventing cruelty to animals.

According to the IRS Publication 557, in the Organization Reference Chart section, the following is an exact list of 501(c) organization types and their corresponding descriptions.

Forming a tax-exempt organization

The tax-exempt organization is not really an entity choice, but rather a declaration of how your particular entity will conduct its business. When used in reference to nonprofit organizations, the term “tax-exempt” generally refers to net profits of an organization (income minus expenses) being exempt from state or federal taxes. While a nonprofit organization can be established by incorporating, the entity is not automatically tax-exempt upon filing the articles of incorporation with the state.

Tax-exempt status can only be achieved by applying and receiving approval from the Internal Revenue Service (IRS). The most common organization is called a Section 501(c)(3) public charity or private foundation, established for purposes that are religious, educational, charitable, scientific, literary, safety-oriented or amateur sports-related. (There are also a number of other IRS-designated organization types that are considered tax-exempt but not charitable. Examples include trade associations, social clubs and certain advocacy organizations involved in political lobbying. Check out the IRS classification chart for additional information.)

The application process is difficult, and professional help is recommended. It requires the filing of IRS Form 1023 within the first 27 months of the organization’s formation. The form is quite lengthy, and a typical application package can range from 25 to 75 pages and take more than 100 hours to complete. A two-tiered filing fee structure ($300 and $750) allows very small organizations to apply at a reduced rate, compared to larger, more traditional tax-exempt organizations.

While the IRS generally rejects less than one-tenth of all applicants, another third are abandoned by the filer either out of frustration or inability to answer IRS follow-up questions. The process typically takes between two to 12 months, depending on the need for follow-up information. A negative determination by the IRS can be appealed, or the organization may choose to apply again, but either way it will be difficult once the initial application is rejected.

Advantages of tax-exempt status. One of the primary benefits of being considered tax-exempt is the ability to accept contributions and donations that are tax-deductible to the donor. Additional benefits include, but are not limited to:

• Exemption from federal and/or state income taxes.
• Possible exemption from state sales and property taxes (varies by state).
• Ability to apply for grants and other public or private allocations available only to IRS-recognized 501(c)(3) organizations.
• Potentially higher thresholds before incurring federal and/or state unemployment tax liabilities.
• The public legitimacy of IRS recognition.
• Discounts on U.S. Postal bulk-mail rates and other services.