Section 501(c)(3) of the IRS Code grants tax exempt status to organizations that are "charitable", "educational", and "religious". This self-help guide is geared primarily towards "charitable" organizations but may also be helpful for others as well.
Every corporation, even a nonprofit, must file a corporate income tax return UNLESS it has been granted an exemption by the IRS. There are twenty-two different types of exemptions listed in Section 501 of the IRS Code. Besides the "(c)(3)" exemption the other types include those for civic leagues, social welfare organizations, labor unions, business leagues, social clubs, farmer's coops, etc.
ADVANTAGE OF 501(c)(3) EXEMPTION
Contributions to a 501(c)(3) entity are tax deductible for the donor
Only 501(c)(3) organizations qualify for foundation grants.
QUICK OVERVIEW OF THE QUALIFICATION PROCESS
To obtain tax exempt status from the IRS you must first create a corporation by filing the appropriate paperwork with your state government (CLICK HERE to download a collection of forms to create a Florida nonprofit corporation suitable for federal tax exemption). Then, you must apply to the IRS for the exemption using either IRS Form 1023 or 1023-EZ.
QUALIFICATION TO BE A 501(C)(3) ORGANIZATION
WORKING DEFINITION: a 501(c)(3) entity is a corporation that is "organized and operated" exclusively for charitable, educational, or religious purposes, no substantial part of whose activities involve trying to influence legislation, does not endorse political candidates, and does not operate for the "private benefit" of insiders (members, founders, directors, etc,) or some other small group of people (though it can pay reasonable compensation for services actually performed).
Now, let's break this down and look at each part of the definition.
ORGANIZATIONAL TEST: the corporation must be "organized" exclusively for charitable purposes. To meet this test specific language must be included in the articles of incorporation. The following two clauses MUST be contained somewhere in the Articles of Incorporation otherwise the non-profit will not qualify for a 501(c)(3) exemption.
The exclusive purpose of this Corporation is to engage in charitable, educational and relgious activities as those terms are used in Section 501(c)(3) of the IRS Code and this Corporation shall not engage in activities that do not further one or more of those purposes (other than as an insubstantial part of its activities).
Upon winding up and dissolution of the Corporation, the assets of the Corporation remaining after payment of all legitimate debts and liabilities shall be distributed to an entity recognized as exempt under section 501(a) of the IRS Code because it is described in section 501(c)(3) of that Code.
CLICK HERE for the documents needed to create a new Florida nonprofit corporation (includes instructions)
CLICK HERE to download a template for "Articles of Amendment" (to amend the documents of a previously incorporated nonprofit to add the IRS required language)
OPERATIONAL TEST: An organization must "operate" "exclusively" for one of the following purposes: charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals. Whether or not the organization is determined to meet this test depends upon what is said in the "narrative" portion of the exemption application. Here is a summary of the requirements for the three primary exempt purposes
relief of the poor and distressed or of the underprivileged
advancement of religion
advancement of education or science
erection or maintenance of public buildings, monuments, or works
lessening of the burdens of Government
lessening neighborhood tensions
elimination prejudice and discrimination
defending human and civil rights secured by law
combating community deterioration
combating juvenile delinquency
Note that "lessening burdens of government" and "combating community deterioration" are general catch-alls which can cover many nontraditional charitable activities. Therefore, a careful description in the narrative section of your application is needed of the "charitable purposes" to be achieved
class room type programs
educating the public about important issues.
There is no set definition but the more a proposed activity looks like something that has traditionally been considered religious the more likely it is that the IRS will grant approval
NO EXCESSIVE PRIVATE BENEFIT. An organization is not organized or operated exclusively for one these purposes unless it serves a public rather than a private interest. an organization must establish that it is not organized or operated for the benefit of private interests such as designated individuals, the founder or his family, members of the organization, or persons controlled, directly or indirectly, by such private interests. Your members and directors are allowed to benefit but only as part of the larger community but not as a privilege inherent in their insider status. If the IRS determines that the main purpose is to bring private benefit the exemption may be denied by the IRS.
"EXCLUSIVELY" vs "SUBSTANTIALLY". To be exempt the organization must be "exclusively" charitable (etc.). You would think it means that an organization can't do anything but conduct charitable activities. However, the IRS and the courts have interpreted "exclusively" to mean "substantially". That is, an organization can carry on "incidental" non charitable activities. For example, a charitable organization can conduct some business activities that are unrelated to its charitable purposes without losing its tax exempt status [see the discussion of "unrelated trade or business" below]. Remember, however, that the IRS will look closely at organizations that operate in a manner that makes charity appear to be only a secondary purpose.
TWO TYPES OF 501(C)(3) ORGANIZATIONS: PUBLIC CHARITY vs PRIVATE FOUNDATION.
In granting 501(c)(3) status the IRS will classify the organization as being either a "public charity" or "private foundation". A private foundation is a 501(c)(3) entity that does not qualify as a public charity. The choice is made by the IRS and not the organization. The classification is based on the sources of the organization's support.
PUBLIC CHARITY (technically: "Publicly Supported Organization") is a 501(c)(3) organization that meets the 1/3 public support test, that is, it receives at least one third of its support from "public" sources such as small contributions, government grants, or from other public charities AND it does not receive too much income from investments. If an organization qualifies it will not be subject to the restrictions applicable to private foundations. For example, The Ford Foundation is a "private foundation" because it does not get any support from the general public or the government and it is not affiliated with or controlled by another organization which itself gets public support. In contrast, your local United Way is a "public charity" because it receives broad public
support. Also, an organization that depends on government grants will likely be classified by the IRS as a "public charity" because government grants are considered a public support.
ADVANTAGES OF BEING A "PUBLIC CHARITY":
Private foundations have more restrictions on their activities
The rules governing the deductibility of contributions are more favorable.
For public charities there is no tax on its investment income [if it has any], while a private foundation must pay a 2% tax
The IRS considers certain organizations to be public charities simply by the nature of their activities (schools, hospitals, religious organizations, etc.) or because the organization is affiliated with or controlled by another public charity.
For most 501(c)(3) organizations, however, the IRS presumes that it will be a private foundation UNLESS that organization can overcome the presumption by demonstrating that a sufficient amount of its financial support comes from "public sources" [small contributions from the general public, grants from governmental agencies, and grants from other public charities].
PRIVATE FOUNDATION STATUS: A "private foundation" is any 501(c)(3) organization that has failed to demonstrate that it is a "publicly charity". CLICK HERE to go to an information page on the IRS website
can only give money to a public charity
excise tax on investment income not given away as grants in a timely manner''
generally, gifts to a private foundation are not tax deductible
a private foundation cannot receive grants from another private foundation.
PRIVATE OPERATING FOUNDATION - A "private operating foundation" is a type of private foundation that might be an attractive option for an organization that can't qualify as a "public charity" yet wants to avoid some of the disadvantages of being a normal private foundation. Private operating foundations are less rigorously regulated by the IRS than other types of private foundations and, like public charities, they can offer their donors the possibility of getting a tax deduction for donations. Somewhat like a public charity they can qualify for certain types of grants from other private foundations. What distinguishes "private operating foundations"" from other types of private foundations is that they must devote most of their resources to the active conduct of its exempt activities
(rather than simply making grants out of their investment income). CLICK HERE to get more information from the IRS website.
RESTRICTIONS ON 501(C)(3) ORGANIZATIONS:
NO UNDUE PRIVATE BENEFIT: The IRS will take away your tax exempt status if feels that the primary purpose is to benefit insiders or an overly small group of people rather that the exclusive furtherance of charitable purposes. This can happen when an insider enters into an arrangement with the nonprofit and receives benefits greater than she or he provides in return. The IRS refers to such insiders as "disqualified persons" - high-level managers, board members, founders, major donors, highest paid employees, family members of any of the above, etc. This is called "private inurement". It can take many forms. Examples include unreasonably high salary payments and certain types of business dealings between the corporation and its directors and officers. This is a MAJOR concern of the IRS
and many of the questions on the application (Form 1023) have to do with potential private inurement.
LOBBYING: the basic rule is that a 501(c)(3) organization cannot attempt to influence legislation either by directly contacting decision makers or indirectly by urging others to do so. This includes local legislation pending before a city or county commission.
An "insubstantial" or incidental amount of lobbying is permitted if an organization is a public charity [see definition below]. These terms are difficult to quantify. Five percent is sometimes use used as an informal guideline, i.e., an organization's staff should not devote more than 5% of its time and or 5% of the organization's annual budget for lobbying. But this is not an official IRS guideline.
However, there is a "safe harbor". A public charity can make lobbying expenditures up to certain specified levels if it makes an "election" with the IRS using the designaged form. Even if the organization exceeds the specified expenditure levels, the worst that can happen is that it will have to pay a tax of 25% of its excessive lobbying expenditures. It doesn't lose its exemption unless it keeps exceeding the limits in subsequent years. For more information go to Publication 557.
CERTAIN ACTIVITIES ARE NOT TREATED AS "LOBBYING". These include  talking to legislators about legislation that might affect an organization's tax exempt status or existence, but this does not include budgetary or funding matters:  activities related to non legislative decisions, such as opposing or supporting the issuance of regulations;  making available the results of nonpartisan studies; and  responding to requests to testify before legislative committees [your organization must be invited in writing by the chairman of the committee].
EDUCATING THE PUBLIC MAY NOT BE LOBBYING. Educating the public about an important issue is not lobbying so long as you don't directly urge people to contact their legislators. It is permissible to do "educational" activities such as nonpartisan research, policy papers, websites, newsletters, trainings, conferences, etc.
NO ENDORSING POLITICAL CANDIDATES: Section 501(c)(3) organizations cannot support or oppose political candidates. No partisan political campaign activities, however minimal, are allowed. Section 501(c)(3) groups can distribute nonpartisan "voter education" information, but such information should be carefully reviewed to make sure that it is a fair presentation of information about all candidates and is not "slanted". It cannot be anything that can be construed as an attempt to persuade the public one way or the other. Also, Section 501(c)(3) organizations are not permitted to allow groups or individuals to use their facilities and equipment to campaign for candidates.
The IRS sometimes recognizes a group of organizations as tax-exempt if they are affiliated with a central organization. This avoids the need for each of the organizations to apply for exemption individually. A group exemption letter has the same effect as an individual exemption letter except that it applies to more than one organization.
All communication with the IRS concerning particular group exemptions is done by the central organization and not the affiliate. Nonprofits that wish to participate in a group exemption as an affiliate must contact the central organization (1) to find out if it is interested in sponsoring a new affiliate and, if so (2) what specific requirements will they impose upon the affiliate,
DETERMINE WHICH APPLICATION FORM TO USE - 1023 or 1023-EZ
Form 1023-EZ is used for certain smaller organizations. It is much simpler than the standard Form 1023 and the filing fee is lower. Unlike the regular Form 1023 it does not require a detailed written description of the organization's activities ("narrative") and it does not require a multi-year break down of the organization's revenues and expenditures. Form 1023-EZ can be used only by organizations that have (or expect to have) annual gross receipts that do not exceed $50,000 and who meet certain other requirements. CLICK HERE for a more detailed explanation
To determine if an organization is eligible for Form 1023-EZ fill out the IRS worksheet ( CLICK HERE to view it.
IF NOT ELIGIBLE FOR 1023-EZ YOU MUST USE THE FULL BLOWN 1023.
OBTAIN AN EMPLOYER IDENTIFICATION NUMBER ("EIN")
Whether you use Form 1023 or Form 1023-EZ you will need to get an "Employer Identification Number" (EIN) from the IRS
You can apply for an EIN on-line through the IRS's website. CLICK HERE to go to the application page.
CLICK HERE for easy to understand instructions on how to prepare and file IRS Form 1023-EZ without the help of a lawyer
COMPLETING FORM 1023
Download The Forms And Read The Instructions: CLICK HERE to download Form 1023. CLICK HERE to download the IRS's instructions (a separate document). The instructions are excellent. Read them carefully. Also, read IRS publication 557.
Prepare the "Narrative": Part IV of Form 1023 asks you to describe in detail your organization's past, present, and future activities. The "narrative" that you create will be one of the attachments to the completed Form 1023. This is the most important question on the entire application because your answer will determine whether or not you meet the "operational test" (see above).
Here are some pointers for your "Narrative"
FIRST SECTION LABELED "BACKGROUND". To help the IRS better understand your activities you can include an optional short section that describes the background or the need that you are trying to address. Tip: label this section "Background" so that the IRS knows that you are not trying to describe the activities themselves
SECOND SECTION LABELED "ACTIVITIES" (with separate labeled subsections for each distinct activity).. Provide detailed descriptions for each activity. If you fail to give sufficient detail the IRS may hold up approval of your application until you answer all of their written questions. Include in your narrative a discussion of how each activity will achieve an IRS recognized exempt purpose (refer to the listing of approved charitable purposes in the section above labeled :"Operational Test"). For each activity provide the following details
What is the activity?
Who conducts the activity?
When is the activity conducted?
Where is the activity conducted?
How does the activity further the organization's exempt purposes?
Percentage of organization's total time allocated to the activity?
How is the activity funded?
If activity involves affordable housing development, give details on the financing, the maximum allowable income levels for the tenants or buyers, etc. CLICK HERE to read about the IRS affordable housing "safe harbor" rules
If the activity involves "economic development", explain why the activity is "charitable" and not for "private benefit". CLICK HERE to read about the IRS rules governing the eligibility of "economic development" activities.
DISCLOSE ONLY CONCRETE ACTIVITIES. Do not include vague ideas that you may or may not implement in the future. Include only those activities that you are presently engaged in or will actually implement during the next two years and that you can describe with some detail. Remember, if you blurt out some vague future plans without providing detail you will be inviting the IRS to ask you follow-up questions after you submit the application thus delaying the granting of the exemption.
INADVERTENTLY IMPLY LOBBYING. Don't inadvertently brag about how you plan to go down to City Hall and demand better code enforcement in order to clean up the neighborhood (etc.). This could be interpreted by the IRS to be lobbying and could trigger follow-up questions from them after you submit your application.
INADVERTENTLY IMPLYING PRIVATE BENEFIT. The exemption will be denied if the IRS determines that the purpose is primarily for private benefit. Be careful not to imply in your narrative that benefits that will be enjoyed by specified individuals or the organization's membership (unless, of course that is to be the case). The activities of an exempt charitable organization must primarily be for the benefit of the public and NOT private interests. Inadvertently implying private benefit in your narrative will invite a follow-up grilling from the IRS after you have submitted your application and thus delay approval.
INSIDERS RECEIVING COMPENSATION. When evaluating your application the IRS will be looking for indications of compensation being paid to insiders such as members of board of directors and the founder. It is OK to pay reasonable compensation for services actually performed BUT payments to insiders raises concerns about possible impermissible private benefit and could result in closer scrutiny of you application by the IRS which might delay or defeat the granting of the exemption. It is best that anyone receiving compensation NOT be a member of the board of directors.
TIP - Naturally the founders of many new organizations want to some day be a paid employee or consultant after funding becomes available. But you don't necessarily have to mention this in the narrative. This would be the case where the funding has not yet been obtained and the organization's board of directors has not formally voted to hire or retain any particular individual. Even if the founders have made an informal decision the ACTUAL formal decision by the board will not be made until some future date after the funding become available.
"UNRELATED TRADE OR BUSINESS": Be careful in describing your activities in the narrative. You don't want to unintentionally leave the impression that an activity is an "unrelated trade or business". Click here for short article discussing this issue. This becomes a problem when your proposed activity is similar to a non-exempt activity carried on by a for-profit business. The bottom line for the IRS is unfair competition. You have to convince the IRS that the proposed activity is going to be operated differently from any similar activities that might be carried on by for-profit businesses.
Some people think that an activity is exempt merely because the profits are to be spent doing something charitable. THIS IS NOT THE CASE. The activity itself must further a charitable purpose.
The IRS will allow you to engage in some unrelated trade or business activities so long as it is not "substantial" (you will be required to pay tax on any profits)
Provide Financial Information Complete Part IX -A ("Statement of Expenses and Revenue"). Don't freak out . . . it looks more complicated than it actually is.
Initially, ignore "revenue" and focus on "expenses".
Don't enter anything onto Form 1023 yet. Instead, create a word processing or spreadsheet file and use it to create a list of the estimated operating expenses for the first year of actual operations.
Include things like rent, salaries, telephone, internet connection, professional fees (such as to pay an accountant), travel, postage, etc. Remember, for a new organization guess work is OK.
Substitute actual data if the organization has a track record and is gone beyond the start-up phase.
Read the instructions for Part IX-A to determine which future or prior years need to be included (it will depend on how long the organization has been in existence).
Then, create separate versions of the expense list for each additional year required to be included in Part IX-A.
For a start-up there may not be any funding for the initial year so adjust the numbers accordingly. For years subsequent to the first operational year perhaps show the expenses increasing modestly to reflect hoped for increases in grant funding.
Now start transferring the expenses over into the appropriate field in Part IX-A
Most expenses (other than compensation paid for services) will end up being lumped into lines #20 (rent) and #23 ("other" expenses - requires an itemized listing as an attachment)
Use Caution when Listing Compensation Paid for Services: If possible (and without lying) avoid showing compensation being paid to insiders (such as people serving on the board of directors or other people in a position to influence corporate decisions).
Overview of the Danger: During an audit the IRS can impose a stiff "excise tax" on both the insider and the exempt organization if they determine that there has been an "Excess Benefit Transaction" - Click Here to read the IRS manual on this topic.
"Excess Benefit Transaction" - A transaction where an exempt organization provides an economic benefit to a "disqualified person" and the amount of the benefit exceeds the value of the services provided in return.
The term "disqualified person" means any person "in a position to exercise substantial influence over the affairs" of an exempt organization is a "disqualified person". This includes employees having management responsibilities and who also serve on the board of directors.
Red Flag - The IRS scrutinizes all exemption applications in an effort to detect any hint that disqualified persons might be receiving compensation (this issue could potentially cause a long delay in the granting of the exemption as the IRS demands answers to follow-up questions.
You've got four choices on Part IX-A of the application for entering compensation paid for services:
line #17 (compensation to officers and directors), or
line #18 (salaries and wages), or
line #22 (professional fees), or
a combination of the above
If possible avoid listing anything on line #17. Try to show all compensation paid for services on either lines #18 or #22. Be truthful, however, because lying to the IRS can result in criminal penalties.
Now, for "revenue". For most organizations typically all revenue will be shown in item #1 ("gifts, grants, and contributions" which includes both government and foundation grants). Obviously for a new organization the source of the funding is not yet know. The IRS understands this. Simply insert into item #1 for each year a number that equals the "total expenses" shown in item #24.
Prepare a "Conflict of Interest Policy" - Prepare the Conflict of Interest policy that is a required attachment to Form 1023 and have it adopted by the applicant's board of directors. Click Here to download the sample conflict policy document recommended by the IRS (it must be edited to make it suitable for particular organizations). Click Here for the annual statement to signed by each director (only the Conflict of Interest Policy and NOT the annual statement are to be attached to the exemption application).
On Form 1023, near the end, there is a final checklist page. Assemble your packet for submission following the order of the documents outlined in that checklist. It gives instructions on where to send the application and how to handle the filing fee
COVER LETTER: prepare a short cover letter to be signed by the corporations president explaining that you are applying for tax exempt status and that your application is attached. Include the following statement: "the attached bylaws are a true and correct copy of the bylaws that are currently in effect".
After getting your application the IRS will give it a quick review and then put it on one of two tracks.
Fast Track: If it seems clear in the initial review that the applicant is organized and operates exclusively for an exempt purpose and there is no hint of problems (such as private innurment, lobbying, political activity, etc) they will place the application on the fast track for approval and you will be notified of that approval in about four to six weeks.
Slow Track: If the initial reviewer perceives issues or red flags the application will be assigned to a revenue officer for further scrutiny. In such case approval (if it is granted) could take up to nine months or more.
You will eventually be contacted and asked to answer questions and/or provide additional information.
CLICK HERE for a page on the IRS website that shows the submission date of the applications currently being reviewed (this gives you an idea of how much longer it will take for them to get to your application)
CLICK HERE for a page on the IRS website containing sample questions that are commonly asked by Revenue Officers.
Answer all questions truthfully and in detail and submit the answers within the time deadlines imposed. In their written communications they will tell you the name of the revenue officer and his or her phone number.
If you have questions you should not be shy about directly calling revenue officer identified at the top of the letter. Often these people are friendly and can be very helpful.
Determination letter: eventually the IRS will either send you a favorable or an unfavorable determination letter. If it is unfavorable, good luck and you have our condolences. If it is favorable, congratulations! Save this letter. It is very important. Not only does it give you critical information about compliance and staying out of trouble with the IRS, but your potential funding sources will almost always ask you for a copy of it.
ANNUAL INFORMATIONAL RETURN - FORM 990
Form 990 series returns are required to be filed by most tax-exempt organizations. Form 990 is the IRS' primary tool for gathering information about tax-exempt organizations, for educating organizations about tax law requirements and ensuring their compliance. Organizations use it to inform the public about their programs. CLICK HERE to go to a page on the IRS website that provides more detailed information about the requirements.
Even near dormant organizations that have engaged in little or no activity are required to file. FAILURE TO FILE FOR THREE CONSEQUTIVE YEARS WILL RESULT IN REVOKATION OF EXEMPT STATUS. Often, however, small organiazations can get away with filing a simplified "postcard" version of the form by using Form 990-N - CLICK HERE to go to an information page on the IRS website.
IRS Publication 526 - Charitable Contributions:Organizations that qualify for status as a charity are described. The publication provides rules for determining the fair market value of donated property and explains limits on the size of a deduction based on 20, 30, or 50% of an individual's adjusted gross income.
IRS Publication 557 - Tax-Exempt Status for Your Organization: (click here for the on-line version). Organizations are guided through the application procedures for obtaining tax-exempt status. Generally, these organizations must complete either Form 1023 or Form 1024 and await a ruling or determination letter from the IRS. If an exemption is granted, it may be effective as of the date of an organization's formation. In some cases, an organization may be issued an advance ruling or determination letter prior to commencing operations. Return and disclosure statements required of exempt organizations are explained.
IRS Publication 598 - Tax on Unrelated Business Income of Exempt Organization:
IRS Publication 1391 - Deductibility of Payments Made to Charities Conducting Fund-Raising Events:Helps sponsors of fund-raising events carefully word the extent of a donor's eligibility for a charitable contributions deduction.
IRS Publication 1771 - Charitable Contributions--Substantiation and Disclosure Requirements:The Revenue Reconciliation Act of 1993's substantiation and disclosure requirements for donors and charities on contributions made after December 31, 1993 are reported. It is recommended that charities familiarize themselves with the new law in order to avoid failure to meet disclosure provisions that might be subject them to penalties.
Normally, any charitable organization seeking 501(c)(3) status must file a Form 1023 application with the IRS. However, there is an exception for churches and very small charitable organizations - §508(c)(1) of the IRS Code
Rules for Very Small Organizations. A charitable organization that is not a private foundation and that has annual gross receipts normally $5,000 or less is not required to file Form 1023 in order to be recognized by the IRS as a 501(c)(3) organization. Organizations that fall below the $5,000/year threshold can essentially "self declare" its 501(c)(3) status.
According to the regulations at 24 CFR §1.508-1(3)(e)(ii) the gross receipts of an organization are normally not more than $5,000 if:
During the first taxable year of the organization the organization has received gross receipts of $7,500 or less;
During its first 2 taxable years the aggregate gross receipts received by the organization are $12,000 or less; and
In the case of an organization which has been in existence for at least 3 taxable years, the aggregate gross receipts received by the organization during the immediately preceding 2 taxable years, plus the current year are $15,000 or less
Self declared exempt organizations must follow all the laws and regulations applicable to every other 501(c)(3) organization. That means, among other things, that each year they must go on line to file Form 990-N (e-Postcard). A self declared exempt organization must contact the IRS Customer Account Services toll-free at (877) 829-5500 before it attempts to file Form 990-N so that an account can be set up (this takes about 2 to 3 months).
Starting with the 2015 tax year self declared exempt organizations will be required to check a box on their Form 990 indicating that they are self-declared.
Rules that Apply Only to Churches. A "church" can also use § 508(c)(1) to self declare its 501(c)(3) status without having to file Form 1023. A bone fide church qualifies for the exemption because its purpose is "religious" (as opposed to "charitable"). Unlike the case of the small charitable organizations discussed above there is no limit on the amount of gross receipts. Click Here to go to an IRS information page that discusses the definition of the word "church". Churches are normally not required to file any version of Form 990 but they must follow all rules applicable to other 501(c)(3) organizations. Often, however, churches choose to go ahead and file Form 1023 because they want to be included on the IRS's official listing of exempt organization (to give potential donors a level of comfort).