“Not for profit” and 501(c)(3) seem to go hand in hand. But something interesting popped up on my radar the other day, it turns out that not every “not for profit” needs to qualify for tax exempt status under the Internal Revenue Code section 501(c)(3) in order to avoid paying taxes on donations. Qualifying for tax exempt status under 501(c) can be a time consuming process, with costly transaction costs for lawyers and accountants. So why the rush to qualify?
Internal Revenue Code 501(c)(3):
Let’s start with the tax code, which says that if an organization is organized and operated exclusively for an exempt purpose, (say, a charity, advancement of religion, defending human and civil rights, and the like), then that organization is exempt from paying taxes on certain items of income. Note I said “certain” items of income.
Additionally, contributions to an exempt entity are tax deductible to those making the contribution. So in that sense there is a benefit to obtaining 501(c) status.
No Taxable Income, No Reason To Get The Exemption
This is where it gets interesting: If a charitable organization has no “taxable” income, then it doesn’t need to get tax exempt status under 501(c). That’s right: if a charitable organization’s income is derived solely from charitable contributions (which are non-taxable), it doesn’t have to pre-qualify under 501(c) with the IRS. Now, of course there are rules: the income must be derived from contributions or donations or grants, that is, people give money with no expectation of anything in return.
In contrast, income derived from unrelated, business-like activities is taxable at the standard business rate. If a person gives money in exchange for something, such as some kind of merchandise, or entry to an event, then it will be considered a business-like activity, and the income derived is taxable. To make matters more confusing, however, if the charity has tax exempt status, then *certain* kinds of unrelated business-like income will be tax exempt, if the income is related to the core purpose of the charity, for example, taking donated clothing and selling it at a discount to make clothing accessible to poor people.
So Why Get The Exemption?
You may decide your nonprofit doesn’t need the hassle of getting the 501(c) exemption. If you’re just raising funds for your little league through a bake sale, it doesn’t make sense to spend hours filling out paperwork, registering with your State’s SOS, paying all sorts of fees.
On the other hand, if your nonprofit has a large donor that wants the tax deduction; or will only qualify for a particular grant if it has 501(c) status, then doing the ground work might make sense. Similarly, if your nonprofit has various sources of business-like income, some of which are related to the core of your mission, some not, it might make sense to get 501(c) status so that your nonprofit, and the IRS, are clear on what is taxable, what is not taxable.
The long and short of it is that every nonprofit’s situation is unique, every fundraising effort has the pitfalls of becoming taxable. Work with an accountant familiar with section 501 of the tax code; and a lawyer such as myself who works with nonprofits to keep them in compliance with state and federal laws.
For legal help with your nonprofit, call me in Asheville at (312) 671-6453.