Most nonprofits don't pay federal income tax, but only if they meet IRS requirements

A tax-exempt nonprofit is an organization that the IRS has approved to operate without paying federal income tax. The organization itself pays no tax on money it receives—whether from donations, grants, membership fees, or earned revenue—as long as that money supports its stated charitable, educational, religious, or social mission. Individual donors who give to these organizations can also deduct those donations from their own taxes.

Tax exemption is not automatic. A nonprofit must explore to the IRS, prove it meets specific requirements, and maintain that status by filing annual reports and following rules about how it spends money. The most common type is a 501(c)(3) organization, named after the section of the tax code that defines it. Other types exist—501(c)(4) social welfare groups, 501(c)(5) labor unions, 501(c)(6) business leagues—but each has different rules about what activities they can do and whether donors can deduct contributions.

Key Takeaways

  • A nonprofit must file Form 1023 or Form 1023-EZ with the IRS and be approved before it becomes tax-exempt; the organization cannot straightforward declare itself nonprofit.
  • 501(c)(3) organizations—the most common type—must use all revenue for charitable, educational, religious, or social purposes and cannot distribute profits to owners or board members.
  • Tax-exempt status does not mean the organization pays no taxes at all; it still owes payroll taxes for employees and sales tax in most states on purchases.
  • A nonprofit must file Form 990 or Form 990-N with the IRS every year to keep its tax-exempt status, even if it has no income.
  • State and local tax exemptions are separate from federal exemption and must be requested through your state's tax authority.

What the IRS requires to grant tax-exempt status

The IRS will only approve tax exemption if the organization meets four core requirements. First, the organization must be organized and operated exclusively for a charitable, educational, religious, scientific, or social purpose—not for profit or private gain. Second, no part of the organization's net earnings can go to owners, members, or board directors; all money must stay in the organization or go toward its mission. Third, the organization cannot spend a substantial amount of money trying to influence legislation or participate in political campaigns. Fourth, the organization must serve a public benefit, not a private one.

The IRS also looks at how the organization is structured. It must have bylaws, a board of directors, and a clear mission statement. The board cannot be made up entirely of family members or people with financial ties to each other. The organization must keep detailed financial records and be prepared to show how money was spent.

Different types of nonprofits have different rules. A 501(c)(3) is the strictest: it cannot lobby heavily and cannot support political candidates at all. A 501(c)(4) social welfare organization can spend unlimited money on political activity but donors cannot deduct their contributions. A 501(c)(6) business league or chamber of commerce can engage in lobbying but exists to benefit its members, not the general public.

how the process works for federal tax-exempt status

To become tax-exempt, a nonprofit must file either Form 1023 (process for Recognition of Exemption Under Section 501(c)(3)) or Form 1023-EZ (Streamlined process for Recognition of Exemption Under Section 501(c)(3)). Form 1023-EZ is shorter and has a lower filing fee, but only organizations with less than $50,000 in projected annual revenue and fewer than certain types of activities can use it. Most new nonprofits file Form 1023, which is longer but covers more situations.

The process requires you to describe your organization's mission, list your board members and their addresses, show a budget for the next two years, and explain how you will serve the public. You must also include your bylaws and a conflict-of-interest policy. The IRS charges a filing fee—currently $275 for Form 1023-EZ and $600 for Form 1023, though these amounts change periodically. Processing typically takes two to four weeks for Form 1023-EZ and four to six weeks for Form 1023, though it can take longer if the IRS has questions.

You do not need to wait for approval before starting your nonprofit's work. Many organizations begin operating while their process is pending. However, tax exemption only takes effect on the date the IRS approves it, not retroactively. If you want donations made before approval to be tax-deductible, you must request retroactive status in your process.

What taxes a tax-exempt nonprofit still has to pay

Tax exemption from federal income tax does not mean a nonprofit pays no taxes at all. The organization must still pay payroll taxes (Social Security and Medicare) for any employees it has. If a nonprofit has employees, it must withhold payroll taxes from their paychecks and send those taxes to the IRS, just like any other employer.

Most states also require nonprofits to pay sales tax on purchases, even though the organization itself is exempt from income tax. A few states exempt nonprofits from sales tax on certain purchases related to their mission, but this varies widely. Some states exempt nonprofits from property tax on buildings used for the nonprofit's work, but again, this is state-specific and must be requested separately.

A nonprofit may also owe unrelated business income tax (UBIT) if it earns money from activities that have nothing to do with its mission. For example, if a nonprofit runs a thrift store to fund its programs, the thrift store income is related to the mission and not taxed. But if the same nonprofit rents out office space to a for-profit business, that rental income is unrelated and may be taxable.

Annual reporting requirements to keep tax-exempt status

Once approved, a nonprofit must file a report with the IRS every year to keep its tax-exempt status. Most organizations file Form 990 (Return of Organization Exempt From Income Tax), which is a detailed financial and activity report. Organizations with less than $50,000 in gross receipts can file the shorter Form 990-N (e-postcard) instead, which takes about 15 minutes to complete online.

Form 990 requires the nonprofit to report total revenue, expenses, officer and board member names and compensation, and a description of the organization's programs. The form is public—anyone can view it on the IRS website or through GuideStar (now Candid). This transparency is part of the trade-off for tax exemption: the public can see how the organization spends money.

If a nonprofit fails to file for three consecutive years, the IRS automatically revokes its tax-exempt status. The organization can reapply, but it will lose the exemption in the meantime and may owe back taxes. Some states also require nonprofits to file annual reports with the state attorney general or secretary of state, separate from the federal filing.

State and local tax exemptions are separate from federal status

Federal tax exemption does not automatically grant state or local exemptions. A nonprofit that is exempt from federal income tax may still owe state income tax, property tax, or sales tax unless it separately requests exemption from the state. Each state has its own process and its own rules about which types of nonprofits may have access to.

Most states use the IRS information letter (the letter saying the organization is 501(c)(3)) as the basis for state exemption, but some require a separate process. Property tax exemption, which is often the most valuable benefit, is usually handled by your county assessor or local tax authority, not the state. You typically must file a form with the assessor's office and prove that the property is used for the nonprofit's charitable work.

If your nonprofit operates in multiple states, you may need to request exemption in each one. Some states charge a small fee for the exemption information; others do it at no cost. It is worth checking with your state's tax authority early, because some states have important date for requesting exemption in a given tax year.

What happens if a nonprofit loses tax-exempt status

The IRS can revoke a nonprofit's tax-exempt status if the organization stops meeting the requirements. Common reasons include: the organization begins distributing profits to owners or board members, it spends too much money on lobbying or political activity, it fails to file annual reports for three years, or it uses its funds for purposes outside its stated mission.

If status is revoked, the organization becomes a regular for-profit business and must pay federal income tax on all its revenue. It also loses the ability to offer tax deductions to donors. Donors who gave money while the organization was tax-exempt can still deduct those donations on their own tax returns, but future donations are not deductible. The organization may also owe back taxes and penalties.

A nonprofit can appeal a revocation or reapply for status if it corrects the problems that led to the loss. However, the process takes time and money, and the organization operates as a taxable entity in the meantime.

Frequently Asked Questions

Can a nonprofit make a profit?

Yes. A nonprofit can earn more money than it spends in a given year. The difference is called a surplus, not a profit. The surplus must stay in the organization and be used for its mission in future years—it cannot be distributed to owners, board members, or employees as a bonus or dividend. This is the key difference between a nonprofit and a for-profit business.

Do donors get a tax deduction when they give to a nonprofit?

Only if the nonprofit is tax-exempt. Donors can deduct contributions to a 501(c)(3) organization on their federal tax return if they itemize deductions. Contributions to 501(c)(4) social welfare organizations and 501(c)(6) business leagues are not deductible. The nonprofit should provide donors with a written receipt stating that it is tax-exempt and that the contribution is deductible.

What is the difference between a nonprofit and a 501(c)(3)?

A nonprofit is any organization organized for a purpose other than making profit for owners. A 501(c)(3) is a specific type of nonprofit that has been approved by the IRS for tax exemption. Not all nonprofits are 501(c)(3)s—some are organized as nonprofits under state law but have not applied for federal tax exemption, or they may be a different type of tax-exempt organization like a 501(c)(4).

How much does it cost to start a nonprofit?

The IRS filing fee is $275 to $600 depending on which form you use. You will also need to pay your state to incorporate as a nonprofit, which typically costs $50 to $200. You may want to hire a lawyer or accountant to help with the paperwork, which can cost several hundred dollars. Many nonprofits start with minimal expense and grow from there.

Can a religious organization be tax-exempt without filing with the IRS?

Yes. Churches and certain religious organizations are automatically tax-exempt under federal law and do not need to file Form 1023 to receive the exemption. However, they must still file annual Form 990-N reports if they have gross receipts over $50,000. Some churches choose to file Form 1023 anyway to have a formal information letter, which can be useful when requesting state or local exemptions.