Most nonprofits don't pay federal income tax, but only if they meet IRS rules
A nonprofit organization can be exempt from federal income tax if it is organized and operated for religious, charitable, scientific, educational, or social purposes — and if it meets specific IRS requirements. The exemption is not automatic. The organization must file for it, prove it meets the rules, and keep meeting them every year or lose the status.
The most common exemption is 501(c)(3), named after the section of the tax code that allows it. A 501(c)(3) organization does not pay federal income tax on money it receives that furthers its stated mission. It also does not have to pay tax on investment income, donations, or grants — as long as that money stays within the organization and is not distributed to owners or shareholders (nonprofits have neither).
State and local tax treatment varies. Some states mirror the federal exemption; others grant it separately or not at all. A nonprofit exempt from federal tax is not automatically exempt from state income tax, property tax, or sales tax. You have to check your state's rules.
Key Takeaways
- Nonprofits must file Form 1023 or Form 1023-EZ with the IRS and be approved before they receive any tax exemption.
- A 501(c)(3) exemption means the organization pays no federal income tax, but the organization's officers and employees still pay personal income tax on their salaries.
- State and local tax exemptions are separate from federal exemption and depend on where the nonprofit is located.
- Nonprofits must file annual tax returns (Form 990 or Form 990-N) to keep their exemption, even though they owe no tax.
- Unrelated business income — money from activities that do not further the nonprofit's mission — is taxable.
How a nonprofit gets tax exempt status from the IRS
The organization must file either Form 1023 (the full process) or Form 1023-EZ (the shorter version for smaller organizations). Form 1023 is longer and costs $600; Form 1023-EZ costs $275 and is available only to organizations with less than $50,000 in annual revenue and fewer than 15 employees. Both forms ask the IRS to verify that the organization's purpose, structure, and planned use of money all match the 501(c)(3) rules.
The IRS typically takes 2 to 4 weeks to approve Form 1023-EZ and 2 to 12 weeks to approve Form 1023, though processing times vary. The organization does not receive tax exemption until the IRS approves the process and issues a information letter. Until then, the organization may owe federal income tax on its revenue.
The organization must also have bylaws, a board of directors, and a conflict-of-interest policy. The board must be made up of people with no financial stake in the organization — they cannot be paid owners or shareholders. Officers and employees can be paid, but their compensation must be reasonable for the work they do.
What tax exempt actually covers and what it does not
A 501(c)(3) exemption covers federal income tax only. The organization does not pay tax on donations, grants, membership fees, or investment income as long as that money is used to further the organization's mission. If the organization earns money from activities unrelated to its mission — for example, a charity that runs a gift shop — that income is taxable as unrelated business income.
The exemption does not cover payroll taxes. A nonprofit must still withhold and pay Social Security and Medicare taxes on employee wages, and it must pay the employer portion of those taxes. Officers and employees report their salaries as personal income and pay personal income tax on them.
State and local taxes are handled separately. Some states automatically grant income tax exemption to organizations with federal 501(c)(3) status. Others require a separate state process. Property tax and sales tax exemptions vary widely by state and sometimes by county. A nonprofit in one state may be exempt from property tax but not sales tax, while a nonprofit in another state faces the opposite rules.
Annual reporting requirements to keep exemption
A nonprofit must file a tax return every year to keep its exemption, even though it owes no federal income tax. Organizations with gross revenue over $50,000 per year file Form 990 or Form 990-EZ. Organizations with gross revenue of $50,000 or less file Form 990-N, which is a short electronic notice filed online.
Form 990 is public. Anyone can view it on the IRS website or on sites like GuideStar. It shows the organization's revenue, expenses, officer compensation, and how money was spent. This transparency is part of the trade-off for tax exemption: the public can see how the organization uses its money.
If a nonprofit does not file the required return for three consecutive years, the IRS automatically revokes its tax exempt status. The organization then owes back taxes and penalties. Restoring exemption requires filing the missed returns and reapplying to the IRS.
Donor benefits and charitable deductions
When someone donates money to a 501(c)(3) organization, they can deduct that donation from their personal income taxes — but only if they itemize deductions on their tax return. The donor receives a receipt from the nonprofit showing the donation amount. The nonprofit does not claim the deduction; the donor does on their own tax return.
The donor must have proof of the donation. For cash gifts under $250, a bank record or receipt from the nonprofit is enough. For gifts of $250 or more, the donor needs a written acknowledgment from the nonprofit stating the amount and whether the donor received anything in return (such as event tickets or merchandise).
Not all nonprofits are 501(c)(3) organizations. Other types of tax-exempt nonprofits exist — 501(c)(4) social welfare organizations, 501(c)(5) labor unions, 501(c)(6) trade associations and chambers of commerce — but donors cannot deduct contributions to them. Only 501(c)(3) donations are tax-deductible for the donor.
What happens if a nonprofit loses or never gets exemption
If the IRS denies the exemption process, the organization can appeal or reapply after fixing the problems the IRS identified. Until exemption is granted, the organization is treated as a for-profit business and must pay federal income tax on its revenue.
If an organization loses its exemption because it stopped meeting the rules — for example, it began distributing profits to board members, or it spent money on activities unrelated to its mission — it must pay back taxes for the years it was exempt but should not have been. The IRS can also impose penalties.
Some organizations choose not to seek 501(c)(3) status. They may operate as for-profit businesses, partnerships, or other structures. They pay income tax but have more flexibility in how they use money and who controls the organization. The choice depends on the organization's goals and funding sources.
State tax exemption is separate and varies widely
Federal 501(c)(3) status does not automatically grant state income tax exemption. Some states — including New York, California, and Texas — automatically recognize federal exemption. Others require the nonprofit to file a separate state process or pay a state filing fee even after federal approval.
Property tax exemption is even more variable. Many states exempt real property owned by 501(c)(3) organizations, but some states require the property to be used directly for the organization's charitable mission. A nonprofit that owns a building and rents out part of it may lose property tax exemption on the rental portion. A few states do not grant property tax exemption to nonprofits at all.
Sales tax exemption depends on the state and sometimes on the type of purchase. Some states exempt nonprofits from sales tax on all purchases; others exempt only purchases directly related to the nonprofit's mission. A few states do not grant sales tax exemption to nonprofits.
Frequently Asked Questions
Can a nonprofit have paid employees?
Yes. Employees and officers can be paid reasonable salaries for their work. They must pay personal income tax and payroll taxes on those salaries. The nonprofit must still pay the employer portion of payroll taxes. The restriction is that no individual can own the nonprofit or receive a share of its profits — all revenue must stay in the organization and be used for its stated mission.
What is unrelated business income and why does it matter?
Unrelated business income is money the nonprofit earns from activities that do not further its mission. A food bank that runs a thrift store to raise money must pay tax on the thrift store's profit, even though the food bank itself is tax-exempt. The nonprofit files Form 990-T to report and pay tax on unrelated income.
Do nonprofits have to pay sales tax when they buy things?
It depends on the state and the purchase. Some states exempt all nonprofit purchases from sales tax. Others exempt only purchases directly related to the nonprofit's mission. A few states do not grant sales tax exemption. You have to check your state's rules or ask your state's tax department.
What if a nonprofit's mission changes?
The nonprofit must notify the IRS of any significant change to its purpose, structure, or activities. If the change means the organization no longer meets 501(c)(3) rules, the IRS can revoke exemption. The organization should file an amended Form 1023 or contact the IRS before making major changes to avoid losing exemption unexpectedly.
Can a nonprofit earn money and still be tax-exempt?
Yes. A nonprofit can earn revenue from donations, grants, membership fees, program fees, investment income, and related business activities. All that money is tax-exempt as long as it is used to further the organization's mission and is not distributed to individuals. The organization must reinvest all revenue into its work.