Nonprofit charitable organizations are curious institutions in American law, defined more by what they aren’t than what they are, because of the way the Internal Revenue Code has evolved. If you think about it, a nonprofit institution is: not for profit, exempt from taxes, and not a private foundation. So what does this mean, and how does it work?
Terminology of 501(c)(3) Organizations
Nonprofit (or not-for-profit). This term doesn’t mean that an organization can’t take in more money than it spends—what we usually think of as “profit.” If that were the requirement, most, if not all, nonprofits would soon fail. What it means is that profit can’t be the reason for its existence, and any surplus funds have to stay in the organization or be spent for charitable purposes. No owners or shareholders can share in these funds, and if the organization fails or is sold, the remaining assets must go to other similar nonprofit organizations.
Tax-exempt. This term generally means that the organization is exempt from federal income tax under Section 501(c)(3) of the Internal Revenue Code. To be exempt from paying state or local business sales, income, and property taxes, you must receive a separate tax exemption from the government involved. In most cases, receiving federal tax exemption automatically gets you state income tax exemption and makes it much easier to receive sales and property tax exemptions from state and local governments.
Not a private foundation. This is the least understood part of tax exemption. To be totally tax exempt and to receive grants, among other things, a 501(c)(3) organization cannot be a private foundation. When Congress laid the groundwork for modern private foundations in 1969, the IRS developed a better sense of what a private foundation is than a public charitable organization. As a result, public charities came to be described as nonprofit corporations that are not private foundations. On a nonprofit’s IRS determination letter, this is usually referred to as 509(a) status.
Federal 501(c)(3) Requirements
To qualify for 501(c)(3) tax-exempt status, an organization must meet the following requirements set by Congress:
- The organization must be organized and operated exclusively for religious, educational, scientific, or other charitable purposes.
- Net earnings may not inure to the benefit of any private individual or shareholder.
- No substantial part of its activity may be attempting to influence legislation.
- The organization may not intervene in political campaigns.
- The organization’s purposes and activities may not be illegal or violate fundamental public policy.
The first step in forming a nonprofit is to incorporate in some state as a “nonprofit corporation” under that state’s laws. Once incorporated, the nonprofit applies for tax-exempt status by filing a Form 1023 with the IRS. If approved, the organization receives a letter granting it 501(c)(3) tax exemption as a Public Charity (see Understanding Your 501(c)(3) Letter below). The organization must stay within the purposes described in its Form 1023, and the Form 1023 must be available for public inspection. If you are being asked to write grants that seem to be far afield from the organization’s mission, check the original Form 1023 to see if the grant project is within the scope of the original application. If it isn’t, the organization should not apply for that grant or, with much deliberation and after consulting an attorney, seek to modify its purpose.
Other Tax-Exempt 501(c) Organizations
There are many other types of organizations exempted under section 501(c) of the Internal Revenue Code, for example, civic leagues under 501(c)(4) and credit unions under 501(c)(14). Two important differences distinguish 501(c)(3)s from all the rest: Donations made to 501(c)(3)s may be deductible from the donor’s taxable income as charitable contributions, and 501(c)(3)s are eligible to receive foundation grants.
Sometimes an organization will set up parallel nonprofit corporations for related purposes. For example, a 501(c)(3) will be created to do educational and service work and to receive grants and contributions, and a 501(c)(4) will be created to do lobbying and support candidates. If you are working for such an organization, be careful to distinguish its grant-supported activities from its ineligible lobbying work.
Non-Private Foundation Status
The IRS assumes that all nonprofits are taxable entities until proven otherwise and that all 501(c)(3) tax-exempt organizations are private foundations until proven otherwise. The differences in proof are significant: Tax-exempt status is based on where your money goes, whereas private foundation status is based on where your money comes from.
Public charities are defined in the tax code by the things that distinguish them from private foundations. These can be either or both of the following:
- What they are: The Internal Revenue Code lists churches or associations of churches; schools, colleges, and universities; hospitals or medical research institutions; governmental units; supporting organizations; public safety organizations; development foundations for state or local colleges or universities.
- Where their funding comes from: Publicly Supported Organizations (PSOs) and Fee/Activity Supported Organizations (FASOs).
There are complex income tests for PSOs and FASOs, but as a general rule, they must receive a minimum percentage of their total support in contributions from the general public, with limited amount from any one person. If a nonprofit doesn’t meet these tests, the IRS can reclassify it as a private foundation.
Nonprofit 501(c)(3) organizations realize significant advantages by not being private foundations:
- They are exempt from paying federal taxes (except for income taxes on any unrelated business).
- They are generally exempt from paying state and local taxes.
- Donations from individuals and corporations are deductible from the donor’s federal and state income taxes as charitable contributions, with fewer restrictions than donations to private foundations.
- They are eligible to receive grants from private foundations.
- They are eligible to apply for certain restricted government grants and contracts.
Being classified as a private foundation means loss of most of these advantages. Of particular importance to the grant professional is the loss of eligibility to apply for and receive foundation and government grants.
