Most nonprofits must file for tax exemption; it is not automatic

A nonprofit organization does not become tax-exempt just by being nonprofit. The organization must meet specific requirements set by the Internal Revenue Service (IRS) and often by your state, then file the right paperwork to claim that status. Many nonprofits operate without tax exemption because they have not filed for it, do not meet the rules, or chose not to pursue it.

Tax exemption means the organization does not pay federal income tax on money it receives that matches its stated purpose. It also means donors may be able to deduct their donations on their own tax returns. But the IRS does not grant this status to every organization that calls itself nonprofit. The organization has to prove it exists for a may have access to purpose and operates according to strict rules about how it spends money and who benefits.

Key Takeaways

  • The IRS requires nonprofits to file Form 1023 or Form 1023-EZ to request tax-exempt status; straightforward being organized as a nonprofit does not grant it automatically.
  • Only certain types of organizations may have access to for federal tax exemption, most commonly those serving religious, charitable, educational, scientific, or social purposes under Section 501(c)(3).
  • A nonprofit that does not file for tax exemption or fails to meet IRS requirements must pay income tax on its revenue just like a for-profit business.
  • States often have separate tax-exemption rules and may grant state tax exemption even if the IRS denies federal status, or vice versa.
  • The IRS can revoke tax-exempt status if an organization stops meeting the rules, such as by distributing profits to owners or spending money on political campaigns.

What the IRS requires to grant tax-exempt status

The most common path to federal tax exemption is Section 501(c)(3) status. The organization must exist for one or more of these purposes: religious, charitable, educational, scientific, literary, testing for public safety, fostering amateur sports, or preventing cruelty to children or animals. The IRS interprets these categories broadly, but the organization's actual work must match its stated purpose.

Beyond purpose, the IRS requires that the organization operate for the public benefit, not for private gain. This means the organization cannot distribute profits to members, shareholders, or officers. Money must stay in the organization and be spent on the stated mission. Officers and employees can receive reasonable salaries, but the organization cannot exist primarily to enrich them.

The organization must also follow rules about political activity and lobbying. A 501(c)(3) organization can do some lobbying and voter education, but it cannot spend a substantial part of its budget on lobbying and cannot spend any money on political campaigns for or against candidates. Violating this rule can result in losing tax-exempt status.

How a nonprofit files for tax-exempt status

A nonprofit that wants federal tax exemption must file Form 1023 (the full process) or Form 1023-EZ (a shorter version for smaller organizations) with the IRS. The form requires detailed information about the organization's purpose, structure, finances, and how it plans to spend money. The IRS uses this information to decide whether the organization meets the rules.

Filing costs money. Form 1023 requires a filing fee of $275. Form 1023-EZ costs $275 as well, but it is only available to organizations that expect to have less than $50,000 in annual revenue and meet other size limits. Many small nonprofits use Form 1023-EZ because it is simpler and faster to process.

The IRS typically takes several weeks to several months to review the process. During this time, the organization can operate as a nonprofit but does not yet have tax-exempt status. Once the IRS approves the process, the organization receives a letter confirming 501(c)(3) status. Donors can then deduct their donations, and the organization does not owe federal income tax.

Nonprofits that do not have tax-exempt status

Some nonprofits choose not to file for tax exemption. A small organization that receives very little money might decide the filing fee and paperwork are not worth it. Others might not meet the IRS requirements and know they would be denied. These organizations still operate as nonprofits under state law, but they must pay federal income tax on their revenue.

A nonprofit without federal tax exemption also cannot offer donors a tax deduction for their donations. This makes fundraising harder because donors lose the tax incentive. The organization must still file a tax return with the IRS each year, just like a for-profit business, and pay tax on any net income.

Some organizations that do not may have access to for 501(c)(3) status may still may have access to for other types of federal tax exemption. For example, social clubs, labor unions, and business leagues can seek 501(c)(7), 501(c)(5), and 501(c)(6) status respectively. These statuses have different rules and different tax treatment, but they still require filing with the IRS.

State tax exemption versus federal tax exemption

Federal tax exemption and state tax exemption are separate. An organization can have one without the other. Many states require nonprofits to file a separate process for state income tax exemption, and some states also exempt nonprofits from property tax and sales tax.

A nonprofit with federal 501(c)(3) status does not automatically receive state tax exemption. The organization must file with the state, usually through the state's tax authority or attorney general's office. Each state has its own rules about what qualifies for exemption and what paperwork is required. Some states accept the federal IRS information as proof of qualification, while others conduct their own review.

In rare cases, an organization might receive state tax exemption but not federal exemption, or vice versa. This can happen if the organization meets one set of rules but not the other. For example, a state might exempt a local nonprofit that does not meet the IRS's definition of charitable purpose.

What happens if a nonprofit loses tax-exempt status

The IRS can revoke tax-exempt status if an organization stops meeting the rules. Common reasons include distributing profits to owners or officers, spending substantial money on lobbying or political campaigns, or failing to file required annual reports. Once status is revoked, the organization must pay back taxes on income from the years it was not in compliance.

The IRS also requires tax-exempt organizations to file an annual information return, usually Form 990 or Form 990-N (an electronic notice for very small organizations). Organizations that do not file this return for three consecutive years automatically lose their tax-exempt status. The organization can reapply, but it must pay the filing fee again and go through the approval process.

If an organization's tax-exempt status is revoked, donors who gave money during the years the organization was not actually exempt cannot claim those donations as deductions. This is why it is important for nonprofits to stay in compliance with IRS rules and file required paperwork on time.

Other types of tax-exempt organizations

Section 501(c)(3) is the most common type of tax exemption, but it is not the only one. Religious organizations can seek 501(c)(3) status, but many do not file because they are automatically exempt under a different rule. Social clubs and fraternal organizations can seek 501(c)(7) status, which exempts them from federal income tax but does not allow donors to deduct donations. Labor unions can seek 501(c)(5) status with similar rules.

Business leagues, chambers of commerce, and trade associations can seek 501(c)(6) status. These organizations are exempt from federal income tax, but again, donations are not tax-deductible. Each type of exemption has different rules about what the organization can do with its money and how it must operate.

Veterans organizations, political organizations, and homeowners associations can also seek tax exemption under different sections of the tax code. The key point is that tax exemption is not one-size-fits-all. The type of exemption an organization seeks depends on its purpose and structure.

Frequently Asked Questions

Can a nonprofit operate without filing for tax-exempt status?

Yes. A nonprofit can operate under state law without filing for federal tax exemption. However, it will owe federal income tax on its revenue, and donors cannot deduct their donations. Most nonprofits file for tax exemption because it makes fundraising easier and reduces the organization's tax burden.

How long does it take to get tax-exempt status?

The IRS typically takes several weeks to several months to review a Form 1023 process. Form 1023-EZ usually processes faster, sometimes in a few weeks. During the review period, the organization can operate as a nonprofit but does not yet have official tax-exempt status.

What if the IRS denies my nonprofit's process for tax exemption?

The IRS will send a letter explaining why the process was denied. The organization can appeal the decision or revise its structure and purpose to meet the requirements and reapply. Reapplying requires paying the filing fee again.

Do all religious organizations have tax-exempt status?

Religious organizations are automatically exempt from federal income tax under a special rule, even if they do not file Form 1023. However, they still must follow the rules about not distributing profits and not spending money on political campaigns. Some religious organizations file Form 1023 anyway to have official documentation of their status.

Can a nonprofit with tax-exempt status pay its employees?

Yes. A tax-exempt nonprofit can pay reasonable salaries to employees and officers. The rule is that the organization cannot distribute profits to owners or pay unreasonably high salaries that benefit individuals rather than the mission. The IRS looks at whether compensation is reasonable for the work performed.