If you ever want to start a nonprofit charitable organization, you need to know a few things about the 501(c)(3), which is the official filing status that makes an organization exempt from taxation. 501(c)(3) is a section of the Internal Revenue Code, and it’s also a shorthand expression for a type of nonprofit organization that has qualified for tax-exempt status. If you want to form a nonprofit, you might hear people simply refer to it as “setting up a 501c3.”
There are various types of 501(c) organizations, but the 501(c)(3) is the type that gives the biggest tax benefits. 501(c)(3) organizations qualify for the following tax benefits:
- Exemption from federal income and employment taxes
- Receive tax-deductible contributions (when people give money to your organization, they can deduct those contributions from their personal taxable income)
- Exempt from paying state employment, income and sales tax
- Exempt from paying federal unemployment tax
- May receive tax-exempt financing
- Save money on postage with reduced postal rates
501(c)(3) organizations receive generous tax benefits because they are supposed to contribute to some kind of socially beneficial mission beyond the pursuit of profit. Tax-exempt charities are basically an expression of idealism and hope for the common good that is written into the tax code.
However, the government doesn’t just give away all of these tax benefits for free — they expect 501(c)(3) organizations to comply with some important rules and maintain some major responsibilities as well. Here are a few:
No Private Benefits
According to the IRS, a 501(c)(3) organization cannot be “organized or operated for the benefit of private interests,” and the organization’s net earnings cannot “inure to the benefit of any private shareholder or individual.” These organizations should serve the public interest, not enrich the owners. This is an anti-corruption rule and a reminder of the overall purpose of setting up a 501(c)(3): charities are supposed to enrich the common good, not make their officers, directors, trustees or employees rich.
For example, according to IRS compliance guidelines, 501(c)(3) organizations are not permitted to allow their income or assets to “accrue to insiders,” such as by paying “unreasonable compensation” or excess benefits to an insider. Basically, nonprofits shouldn’t operate like personal piggy banks for the directors and officers, and they’re not supposed to pay excessively high salaries or bonuses to employees or contractors. Nonprofits are required to pay fair market value for services rendered or property purchased by the organization. This article in SHRM has a good overview of the types of excess benefit transactions that your nonprofit should avoid.
Just like companies and individuals are required to file annual tax returns, 501(c)(3) organizations are required to file an annual return — Form 990 — even though the organizations are exempt from taxes. If your organization does not file your Form 990 or files late, you may be required to pay penalties to the IRS. And if you fail to file your Form 990 for three consecutive years, your organization automatically loses its tax-exempt status.
Your nonprofit is required to keep detailed records of its financial information, including income, expenses, credits and the supporting documents for these records. Your organization is also required to keep records on file for as long as necessary to comply with the Internal Revenue Code within the statute of limitations for a return — usually at least 3 years after the date that the return is due or filed.
Limits on Political Activity
Since 501(c)(3) organizations are tax-exempt, they are not supposed to participate in political campaigns or lobbying activity. This means they cannot participate in or contribute to political campaign funds, or make public statements on behalf of candidates for public office. If you want your nonprofit organization to be involved in lobbying or supporting political candidates, you need to set it up as a 501(c)(4) organization instead — but donations to these organizations are not tax-deductible.
- Decide whether your organization is a Trust, Corporation or Association.
- Create an organizing document for your nonprofit (like Articles of Organization for an LLC).
- Make sure your organization’s purposes are clearly stated in the organizing document, and make sure the purposes of your organization are officially “exempt.” Exempt purposes include: religious, charitable, scientific, testing for public safety, literary or educational, fostering national or international amateur sports competition, or preventing cruelty to animals.
- Your organizing document should also permanently dedicate your organization’s assets to its exempt purpose.
- Comply with state registration requirements. Depending on your state, you may need bylaws (internal operating rules) to make sure your organization is in compliance.
- Get an Employer Identification Number (EIN) for your nonprofit
By following the rules and complying with the requirements, you can maintain your 501(c)(3) status and keep making a bigger difference in the world for years to come!
Are you ready to start a 501(c)(3) organization? Talk to Incfile today! We offer a variety of premium nonprofit services to help get your 501(c)(3) organization launched, approved and on track for success.