Understanding Tax Exempt Status: What It Means and Who Can Have It
Tax exempt status is a designation granted by the Internal Revenue Service (IRS) that allows certain organizations to operate without paying federal income taxes. When an organization receives this status, it means the organization does not owe federal income tax on money it receives, as long as that money supports the organization's stated mission.
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The most common type of tax exempt organization is a 501(c)(3) organization, named after the section of the tax code that describes it. These organizations must operate for charitable, religious, educational, scientific, or social purposes. Other types of tax exempt organizations exist under different sections of the tax code, including 501(c)(4) social welfare organizations, 501(c)(5) labor unions, 501(c)(6) business leagues and trade associations, and 501(c)(7) social and recreational clubs.
It's important to understand that tax exempt status does not mean an organization is free from all regulations. These organizations must follow specific rules about how they use their money, who they serve, and how they report their activities. They must keep detailed records and file annual reports with the IRS showing where their money came from and how they spent it.
Tax exempt organizations are often called nonprofits, though not all nonprofits have tax exempt status. Some organizations are structured as nonprofits under state law but still pay federal income taxes. Conversely, some tax exempt organizations may be for-profit in structure but meet the requirements for tax exempt treatment under federal law.
The primary reason tax exempt status exists is to encourage organizations that serve the public good. By not requiring these organizations to pay income taxes, the government recognizes that their work provides value to communities. This means more money can go toward the organization's mission rather than toward taxes.
Practical Takeaway: Tax exempt status is a legal designation that affects how an organization pays taxes and files reports. Understanding what tax exempt status actually means—and what it doesn't mean—is the foundation for learning about the requirements and rules that govern these organizations.
The IRS Application Process and Required Forms
Organizations seeking tax exempt status from the IRS must submit Form 1023 or Form 1023-EZ, depending on their size and type. Form 1023 is the full Application for Recognition of Exemption Under Section 501(c)(3). This form includes detailed questions about the organization's structure, mission, activities, and financial projections. Organizations must provide information about their board of directors, their planned programs, and how they will use donations.
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Form 1023-EZ is a shorter version for smaller organizations. It can be filed online and costs less than the full form. To use Form 1023-EZ, an organization generally must have projected annual gross receipts of no more than $50,000 and total assets under $250,000. The form still requires detailed information about the organization's purpose and activities, but in a simplified format.
Before submitting either form, the organization must first obtain an Employer Identification Number (EIN) from the IRS. This is a nine-digit number that functions like a Social Security number for organizations. The EIN is used for tax filing, employment records, and banking purposes. Organizations can obtain an EIN for free by applying online, by mail, or by phone.
The IRS charges a filing fee for both forms. As of 2024, Form 1023 costs $600, while Form 1023-EZ costs $275. These fees are non-refundable, meaning organizations pay them even if their application is not approved. Some organizations with very limited income may request a fee waiver, though approval is not guaranteed.
After submitting the application, the IRS typically reviews it over several months. During this time, the IRS may request additional information or clarification about the organization's activities and finances. Organizations should be prepared to provide more details if asked. Once approved, the IRS sends a determination letter confirming the organization's tax exempt status.
Practical Takeaway: The application process requires careful preparation of forms and detailed documentation of the organization's mission and finances. Starting with an EIN and understanding which form applies to your organization's size will help guide the next steps in the process.
Core Requirements for Maintaining Tax Exempt Status
Organizations with tax exempt status must meet ongoing requirements to keep that status. The most fundamental requirement is that the organization must operate exclusively for its stated exempt purpose. This means that all activities and all use of money must further the organization's charitable, religious, educational, scientific, or social mission. Even one activity that primarily benefits private individuals rather than the public can jeopardize tax exempt status.
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Tax exempt organizations must not engage in substantial legislative lobbying, meaning they cannot spend large amounts of money trying to influence laws or regulations. However, some lobbying is permitted. A 501(c)(3) organization may spend up to 20% of its first $500,000 in annual gross receipts on lobbying activities. Organizations can track their lobbying spending and stay within these limits.
Absolutely prohibited for tax exempt organizations is campaign activity. Organizations cannot spend money supporting or opposing candidates for political office. This is a bright-line rule with no exceptions. Even a small donation to a political candidate or a statement expressing support for one candidate over another can result in loss of tax exempt status.
Organizations must distribute their net income to further their mission, not to individuals who control the organization. This is called the non-distribution constraint. If an organization closes or dissolves, any remaining assets must go to another tax exempt organization with a similar mission, not to board members or founders.
Another key requirement is transparency. Tax exempt organizations must make their annual Form 990 (or Form 990-N for very small organizations) available to the public. This form shows the organization's revenue, expenses, and how money was used. Many organizations now post these forms on their websites so anyone can see how the organization operates and spends its money.
Practical Takeaway: Maintaining tax exempt status requires ongoing adherence to rules about the organization's primary purpose, restrictions on lobbying and political activity, and transparency through public reporting. Organizations must treat these requirements seriously throughout their existence, not just when first applying.
Annual Reporting and Record-Keeping Obligations
Tax exempt organizations must file annual reports with the IRS showing their financial activity and programs. The most common form is the Form 990 Return of Organization Exempt From Income Tax. This form includes detailed sections about the organization's mission, its programs and accomplishments, its revenue sources, and how it spent its money. The form requires information about salaries for the organization's top employees and details about board members and key staff.
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Organizations with less than $50,000 in annual gross receipts may file Form 990-N, which is an electronic notice. This shorter form simply confirms that the organization is still operating and still meets the requirements for tax exempt status. Form 990-N is filed online and is much simpler than the full Form 990, though organizations must still maintain detailed records to support their filing.
The deadline for filing the annual Form 990 is typically May 15 of the year following the organization's fiscal year, though organizations can request an extension. For example, an organization with a calendar year ending December 31 would file by May 15 of the following year. An extension can move this deadline to November 15 of that year, giving organizations more time to gather information and prepare their report.
Beyond federal reporting, most organizations must also file reports with state authorities. Many states require nonprofits to register and file annual reports with the state's charity regulator or secretary of state. These state reports may include financial information, information about the board of directors, and details about programs operating in that state. Requirements vary by state.
Organizations must keep detailed records supporting everything reported on their forms. This includes receipts and documentation for all expenses, records of all donations and their sources, payroll records showing what employees were paid, and descriptions of all programs and activities. The IRS does not require organizations to keep records for a set number of years, but standard practice is to keep records for at least seven years. These records must be organized and available if the IRS requests them during an audit.
Practical Takeaway: Annual reporting is not optional—it's a requirement organizations must meet to keep their tax exempt status. Setting up systems to track income and expenses throughout the year, rather than trying to gather this information at filing time, will make annual reporting much simpler and more accurate.