Some people think that just by creating a nonprofit corporation, the nonprofit is tax-exempt. That is not the case. Incorporating a nonprofit in the state of formation merely establishes it as a legal business entity.
To become a tax-exempt nonprofit, you must apply for tax-exempt status with the IRS and be approved.
What does tax-exempt status mean?
Being tax-exempt means that the net profits of the nonprofit organization are exempt from federal income taxes. Certain states allow state-level tax-exempt status, and in such cases, the net profit is also exempt from payment of state income taxes.
Steps for obtaining tax-exempt status for your nonprofit:
- Incorporate. Nonprofit incorporation creates your nonprofit with your chosen home state. Also, a copy of your Articles of Incorporation will be required when you apply for tax-exempt status.
- Apply for an EIN. Every nonprofit seeking tax-exempt status must have an Employer Identification Number regardless of whether it has employees. Form SS-4 is filed with the IRS to obtain an EIN.
- Provide a detailed business purpose. In your Articles of Incorporation, you need to provide a detailed explanation of what the nonprofit is being created to do/provide. The IRS will consider this information as it reviews your application for tax-exempt status.
- File Form 1023 with the IRS. Most nonprofit corporations apply for tax-exempt status under Sec. 501(c)(3). To apply for 501(c)(3) tax-exempt status file Form 1023. Form 1023 is around 30 pages long without the schedules and attachments. Among the required attachments are the corporation’s Articles of Incorporations and bylaws. Be sure to file the most recent version of the form – which was revised last in December 2017. The IRS estimates preparation time of over 100 hours for completion, and IRS approval can take anywhere from a few months to around a year, depending on the number of written follow-up questions the IRS has and how quickly you provide answers. Smaller nonprofits may be eligible to file Form 1023-EZ. This form must be filed electronically. (Nonprofits seeking tax-exempt status under a section of the Internal Revenue Code other than 501(c)(3) file different forms.)
- Pay the necessary filing fees. The IRS charges a user fee of $600 for filing Form 1023 and $275 for filing Form 1023-EZ.
- When to file. Most nonprofits file this application by the end of the 27th month after incorporation. By doing so they will be recognized as tax-exempt from the date of creation. A nonprofit that files after the 27th-month deadline will be recognized as tax-exempt from the date of the application.
- Complete the state-level application (if applicable). Many states do not have a separate tax-exempt application. Some states have a one- or two-page form that must be completed while others have a more detailed application process.
Types of tax-exempt status for nonprofits
There are different types of tax-exempt nonprofits. As noted earlier, the most well-known and common is 501(c)(3), which are public charities or private foundations established for purposes that are religious, educational, charitable, scientific, literary, testing for public safety, fostering of national or international amateur sports, or prevention of cruelty to animals and children. There are, however, 501(c)(4) through 501(c)(27) organizations, which are tax-exempt but not charitable. (The numerical identifier of nonprofits, such as 501(c)(3), references the section of the Internal Revenue Code under which they were granted their tax-exempt status.) View the IRS Organization Reference Chart for a listing of nonprofit classifications.
Benefits of tax-exempt status
In addition to being exempt from federal and state income taxes, tax exemption offers other benefits:
- Donations to the nonprofit are tax-deductible. With 501(c)(3) nonprofits, donations are tax-deductible to the donor.
- Access to grants earmarked for 501(c)(3)s. Certain grants and other public allocations are only available to 501(c)(3) organizations.
- Possible state and local sales and property taxes exemption. This benefit varies by state.
- Credibility. There is established credibility for an organization that is recognized by the IRS as a tax-exempt nonprofit.
- US Postal Service discounts. Tax-exempt nonprofits generally can receive reduced postal rates.