In the long process of establishing a nonprofit, obtaining tax exempt status is a critical step. A tax-exempt nonprofit can avoid paying federal income taxes and federal unemployment tax, can accept tax-deductible contributions from donors and can even save on postal costs. Obtaining tax exempt status on the federal level may also exempt a nonprofit from paying sales, property and income taxes on the state level.
Applying for tax exempt status follows several other key steps. First the organization must file its articles of incorporation with the state and create its bylaws. These can be complicated processes that are governed by both state law and IRS requirements. Leaders establishing new nonprofits work closely with business and tax attorneys to draft legally sound documents and make sure they’ve put all the necessary structural pieces in place to get started. Once the nonprofit has its organizing documents and obtains an Employer Identification Number from the IRS, it’s ready to apply for tax exempt status.
Applying for Federal Tax Exempt Status
How an emerging nonprofit obtains tax exempt status depends on its core mission. Nonprofits with charitable purposes (like the American Red Cross or food banks) apply as 501(c)(3) organizations for tax exempt status. If an organization is designed to provide specific services to individuals in need, it’s almost certainly a 501(c)(3) nonprofit.
The most common alternative nonprofit type is a 501(c)(4) organization, which works to promote general social welfare. The ACLU and Sierra Club are examples of 501(c)(4) nonprofits. Unlike charities, these groups can engage in lobbying and have a different set of rules than 501(c)(3)s.
Applying as a 501(c)(3)
A 501(c)(3) nonprofit uses Form 1023 or Form 1023-EZ to obtain tax exempt status. To help nonprofits determine which form to complete, the IRS provides a series of 30 screening questions in the Instructions for Form 1023. If a nonprofit can answer “no” to all the questions, it’s eligible to submit the streamlined 1023-EZ instead of the longer 1023. Some of the things that will disqualify a nonprofit from using 1023-EZ include projecting annual gross receipts exceeding $50,000 over the next three years; having total assets valued above $250,000; or being a church, school or hospital. Many newly-formed nonprofits will be able to answer “no” to all these questions and use the shorter form.
Both 1023 and 1023-EZ must be filled out and submitted online, through Pay.gov. While the latter is streamlined, both applications ask extensive questions about a nonprofit’s structure, organizing documents, revenue sources and specific activities. Nonprofit leaders may need to seek advice from their business attorneys and other advisors while completing the 1023 or 1023-EZ.
Nonprofits submitting either form will also have to attach supporting documentation. The IRS asks each applicant to create a single PDF file containing its organizing document, plus (as applicable): any amendments and bylaws, a power of attorney form, a tax information authorization form, any supplemental responses to application questions and an expedite request (if the nonprofit has a compelling reason to need its application processed quickly). The nonprofit must also pay a fee with its application. Then the waiting begins. It may take several months for the IRS to inform the organization of its decision.
Applying for Tax Exempt Status as a 501(c)(4)
Groups that meet the criteria of social welfare nonprofits may apply for federal tax exempt status, though they may not be eligible for all the same benefits as 501(c)(3)s at the state level. Social welfare organizations don’t use Form 1023. Instead, they must submit two items to the IRS: Form 8976 (Notice of Intent to Operate Under Section 501(c)(4)) and Form 1024-A (Application for Recognition of Exemption Under Section 501(c)(4)). Again, a business attorney with nonprofit experience can advise 501(4)(c) organizations through the tax exemption process.
Obtaining Massachusetts Tax Exemptions
Once a nonprofit receives notification of its tax exempt status from the IRS, it can then apply for tax exempt status on the state level. (Naturally, this process varies from state to state, so nonprofits should rely on their business attorneys and other advisors for specific guidance.)
In Massachusetts, an organization that’s exempt from federal income tax is also automatically exempt from paying state excise tax. 501(c)(3) nonprofits can also obtain a sales tax exemption, applying via MassTaxConnect. Once approved by the Department of Revenue, the organization is issued a Certificate of Exemption that it can provide to vendors to prove its status. Massachusetts nonprofits may also be eligible for property tax exemptions. These exemptions are administered at the local level by the town or city board of assessors.
Maintaining Tax Exempt Status
Obtaining tax exempt status is a big win for a nonprofit. It would be a shame to lose those benefits because of an administrative oversight. An organization can lose its tax exempt status in many ways, including deviating from its original purpose without informing the IRS or not meeting its annual reporting requirements. Nonprofit leaders must be clear about the legal responsibilities associated with tax exempt status, and work with their advisors to guarantee compliance.
The business and tax attorneys at Sassoon Cymrot Law, LLC work closely with nonprofits to establish and maintain their organizations, including assisting them to obtain tax exempt status. Have questions? Contact us today.