This post is part of a series designed to help you register a high-impact startup. Here, we focus on tax exemption procedures specific to the US, although similar processes may be common in other jurisdictions.
What’s a nonprofit?
A nonprofit is a type of corporation that has measures in place to keep it socially responsible. (So, a little bit like a B-Corp — discussed in Choose a business structure.) These measures are more stringent if the nonprofit is a charity.
What’s a charity?
A charity is a type of nonprofit — one that has a specific designation of the IRS tax code. Therefore, all charities are nonprofit organizations, but not all nonprofits are charities.
The nonprofit entity is established at the state level and can apply to be recognized as a tax-exempt charity at the federal level.
Charities are subject to the following criteria:
- Structure: The organization must be a nonprofit corporation; if it dissolves, assets must be given to another qualified public charity with a similar mission.
- Operations: The organization must operate within the charitable mission, and follow additional tax requirements.
- Lobbying: Lobbying must be limited, and private foundations must not award grants to a public charity that has activities that involve influencing legislation.
- Political activity: The organization must not engage in any political activity.
- Private benefit: The organization must not provide private benefit to insiders or outsiders, except for a “charitable class” — a sufficiently large or indefinite group that benefits from a grant.
Here are some pros and cons associated with turning your nonprofit into a charity:
Pros of a charity |
✅ Tax exemption ✅ Ability to solicit donations from the public ✅ Tax-deductible donations ✅ Encourages public trust |
Cons of a charity |
❌ Must have a charitable purpose and act exclusively under that purpose ❌ Campaign and lobbying restrictions ❌ Increased filing and reporting requirements which are often open to the public ❌ Application process can be difficult and time-consuming |
Nonprofits can also take the structure of a fiscal sponsorship; see Exit your fiscal sponsorship for more information on finding a new fiscal sponsor.
(A tax-exempt nonprofit that isn’t a charity would typically be a private foundation — typically controlled by a small group/family, and funded by fewer sources e.g. investment income.)
501(c)
The 501(c) designation refers to various types of nonprofit organization that are exempt from federal income tax under section 501(c) of the US Internal Revenue Code.
There are dozens of 501(c) variants, but for our purposes we’ll focus on just two:
- 501(c)(3): Organizations that are operated exclusively for religious, charitable, scientific, literary or educational purposes.
- 501(c)(4): Social welfare organizations, such as civic organizations or neighbourhood associations.
| 501(c)(3) | 501(c)(4) | |
| Pros | ✅ Exempt from most federal income tax ✅ Donors can donate tax-deductibly |
✅ Exempt from most federal income tax ✅ May participate in political campaigns and elections |
| Cons | ❌ Can’t participate in political campaigns and elections ❌ Operations restricted to charitable purposes |
❌ Donors must pay tax on donations ❌ Income spent on political activities is taxable |
If you plan on running political campaigns or policy advocacy, we recommend registering as a 501(c)(4). Otherwise, a 501(c)(3) is your best bet for limiting tax, soliciting donations (from individual donors, foundations, and governments), and fostering a positive and politically-neutral public perception.
Application process
Before applying for tax exemption, you must first:
- Choose a business structure
- Write your business plan
- Build a board of directors
- Incorporate your organization
- Obtain your EIN
Once these are done, you must:
- Complete IRS Form 1023 or 1023-EZ. Depending on your size and anticipated revenue, you’ll file either Form 1023 (long form) or Form 1023-EZ (short form). The short form is for organizations with expected gross receipts of $50,000 or less and current total assets of $250,000 or less.
- Provide required documentation. Gather and include necessary documents such as your articles of incorporation, bylaws, financial statements, and a narrative of your activities.
- Pay the fee. There is a filing fee of ~$600 that must be paid when submitting your application. (Fees vary based on the form and your organization’s projected revenues.)
- Submit the application. Submit your completed application and supporting documents to the IRS, either electronically (for Form 1023-EZ) or by mail (for Form 1023).
Depending on your state’s requirements, you may then need to register as a charity with the state’s attorney general or another appropriate state agency. Then you can apply for any applicable state tax exemptions (like sales tax), and await your IRS determination.
You’ll receive a determination letter, which is critical for establishing your tax-exempt status and for donor records.
Instead of submitting the application yourself, you might consider outsourcing the process to a reputable third party like Instant Nonprofit.
Maintaining tax exemption
As a 501(c) charity, your organization must do the following to maintain tax-exempt status:
- Pay tax on “unrelated business income.”
- File an annual information return (Form 990: “Return of Organization Exempt From Income Tax”).
- Publicly share filed Form 990s for the past three years.
Stay tuned for our next post: File forms with the government.