Before you can be sure that tax-exempt status is right for you, you’ll need to understand some of the benefits and responsibilities that come with tax exemption, the steps required to become tax-exempt, and the rules your organization must follow after you apply.
Before you can be sure that tax-exempt status is right for you, you’ll need to understand some of the benefits and responsibilities that come with tax-exemption, the steps required to become tax-exempt, and the rules your organization must follow after you apply.
You must admit there are a lot of financial benefits to applying for tax exempt:
- exemption from federal income tax
- contributions to your organization are tax-deductible
- you may be exempt from paying state income, sales, and employment taxes.
- you have access to reduced postal rates
- you are exempt from paying federal unemployment tax, and
- you can receive tax-exempt financing.
With all these great benefits, comes great responsibilities.
Responsibilities include recordkeeping, certain annual filing requirements, and disclosure requirements.
• Keep detailed recordkeeping
You should keep detailed records, including records you’d probably want to keep for any business. For example, you’re required to keep books and records detailing all activities, both financial and non-financial.
Annual Filings can include
• Form 990
• Form 990-EZ
• Form 990-N (Post Card)
The IRS doesn’t need to see all of your records on a regular basis. But the records you keep will allow you to have everything you may need to submit your required annual filings.
Most public charities recognized as tax-exempt under section 501(c)(3) of the Code are required to file an annual information return: either Form 990 or Form 990-EZ.
Certain categories of organizations are exempted from filing Form 990 or Form 990-EZ – including churches and very small organizations. However, most small organizations that aren’t required to file Form 990 or 990-EZ must file an annual electronic notice, the Form 990-N, also known as the e-Postcard.
There are specific records that need to be made public upon request. Section 501(c)(3) organizations must make their exemption application and the three most recent annual information returns (your Form 990s) available to the public, upon request and without charge (except for a reasonable charge for copying). If your organization has $1,000 or more in gross income from an unrelated business, it must file Form 990-T,
Exempt Organization Business Income Tax Return, and that must be made available as well.
You should make the documents available at the organization’s principal office during regular business hours and requests can be made in person or in writing
Tax-exempt organizations are commonly referred to as 501(c)(3)s. 501(c)(3) includes both public charities and private foundations. The 501(c)(3) is a process with a life cycle, there are 5 steps to a life cycle of a tax-exempt organization:
- Starting out number
- Applying for exemption number
- Require filings
- Ongoing compliance and
- Significant events
The first two steps, starting out and applying for exemption, are unique because you should only do them once for any single organization. For the purposes of this tutorial, we’re only going to concentrate on creating and maintaining one organization at a time.
What’s different about the other three steps is that a single organization has to deal with each of those issues multiple times. Some required filings are annual, for example.
Lifecycle – Starting Out
When you’re creating your organization, you may need to create organizing documents based on the requirements of your state. You’ll need these if you apply for tax exemption. If you’d like to apply for tax exemption, which is a federal level status, you’ll need to acquire an employer identification number, or EIN.
Even if you have no employees, you still need an EIN. Your EIN is similar to your personal social security number, only it’s for your business. It identifies you to the IRS.
Next, you need to determine what type of tax-exempt organization you have. You’ll need this information when you apply for tax-exempt status.If you decide to apply, you’ll probably need more information on the EIN.
Lifecycle – Applying for Exemption
- Apply to the IRS for Tax-Exempt Status
- Form 1023
To apply for tax exempt status, you’ll need to fill out Form 1023 or Form 1023-EZ
You may be eligible to file Form 1023-EZ, a streamlined version of the application for recognition of tax exemption. You must complete the Form 1023-EZ Eligibility Worksheet in the Instructions for Form 1023-EZ PDF to determine if you are eligible to file this form. If you are not eligible to file Form 1023-EZ, you can still file Form 1023.
– Lifecycle – Required Filings
Once the IRS has granted your organization tax-exempt status, it’s important that you meet the mandatory annual filing requirements. You’ll need to file annual exempt-organization returns, and you could be required to file unrelated business income tax filings and other returns and reports to StayExempt.
Lifecycle – Ongoing Compliance
An organization can avoid jeopardizing its taxexempt status. To do that, you’ll need to understand employment taxes, public disclosure requirements, and other ongoing compliance issues.
Lifecycle – Significant Events
Significant events all have to do with your tax-exempt status. The events include, but aren’t limited to:
• Private letter rulings and
• Termination proceedings
An organization must have one or more specific purposes to qualify as tax-exempt. A 501(c)(3) organization (also known as a public charity) is one that is organized and operated exclusively for purposes that are:
• Testing for public safety
• Literary or educational
• Designed to foster national or international amateur sports competition, or
• For the prevention of cruelty to children or animals.
There are many kinds of organizations that fall under these categories. For example, organizations that provide relief to the poor, distressed or underprivileged; those that lessen neighborhood tensions; or those that defend human and civil rights usually qualify as charitable organizations. Educational organizations can be schools, museums, symphony orchestras, training for the unemployed, dance classes, and zoos.
Apply for an EIN
The first step is to apply for an EIN, there are a number of ways you can apply for an EIN. The fastest is to go to the IRS website or call our toll-free number and get an EIN you can use immediately. You can also fax your Form SS-4, Application for Employer Identification Number, and you’ll receive your EIN within 4 business days. or do it the old-fashioned way by completing Form SS-4 using the form’s instructions and mailing it to:
Internal Revenue Service Center
Attn: EIN Operation
Cincinnati, OH 45999
Visit the IRS website for more information
Next, you’ll need to gather your organizing documents. An organization can’t qualify for exempt status without an organizing document. To qualify for exemption under Section 501(c)(3), the organizing document must contain three provisions. See sample document.
By-laws are an organization’s internal operating rules. Federal tax law doesn’t require specific language in the by-laws of most organizations. However, state law may require you to have by-laws, so it is a good idea to contact your state to find out the specific requirements.
Organizational and Operational tests
All types of tax-exempt organizations must meet the Organizational and Operational tests
The Organizational Test is used to determine if the organization is
properly organized. To pass this test the organization must:
• Limit its purposes to one or more of the exempt purposes listed in Code section 501(c)(3)
• Not permit the organization to engage in a nonexempt activity and
• Assets of the organization must be permanently dedicated to an exempt purpose.
If you write your organizing documents correctly and include these provisions you need to have in your organizing documents, this test will be easy to pass.
The Operational Test
The operational test covers how your organization is actually operated. To pass the operational test, your organization must show that its principal activities will be to further its exempt purposes. Conversely, your organization has to limit the participation in certain kinds of
activities and absolutely refrain from others.
Though this test is conducted when you’re first applying for tax-exempt status, if the balance of your activities gets out of line after you receive your status, or your organization engages in prohibited activities, you can lose your tax-exempt status and be subject to both taxes and penalties.
Some prohibited activities including intervening in political campaigns.
If your organization openly endorses a candidate, that’s a prohibited activity. There are many other kinds of political (and other) activities that aren’t allowed which could possibly jeopardize your tax-exempt status such as unrelated business income, required discourses, and employment issues.
Public Charity versus Private Foundation
• Organizations providing medical or hospital care (including medical education and research)
Other Public Charities
• Organizations that receive significant public support
• Organizations that provide support to other public charities.
When an entity qualifies as a tax-exempt organization, the IRS presumes
it’s a private foundation unless it can show that it’s a public charity.
The main difference between a public charity and a private foundation is where the money comes from. Generally, a public charity has a broad base of support while a private foundation has very limited sources of support. There are also different tax rules – so, for example, public foundations are subject to excise taxes that aren’t imposed on public charities. There are more differences – there is more difference but for now, I will focus on public charities.
Some organizations automatically qualify as public charities based on the Code, so they’re called Statutory Public Charities. Some examples are churches, schools, and organizations providing medical or hospital care (including medical education and research).
These organizations still have to pass the Operational and Organizational tests. Or, if your organization receives significant public support or it provides support to other public charities, you may qualify that way. Otherwise, you’ll have to demonstrate you are a public charity by other means.