How to Obtain and Retain Tax Exempt Status
In order to organize as a tax-exempt charitable organization, your company must meet the requirements of Internal Revenue Code Section 501(c)(3). Likewise, you must continue to meet these requirements in order to retain your exempt status and avoid revocation.
To qualify for tax-exempt status, the organization must be organized and operated only for exempt purposes. Exempt purposes include charitable purposes, which means relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency. Exempt purposes also include religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.
To qualify as a charitable organization, the business must be a corporation (or unincorporated association), community chest, fund, or foundation, including a charitable trust. An individual cannot qualify as a charitable organization. The incorporating or organizing documents must specify the qualifying purposes and limit the organization’s activities largely to those purposes.
Importantly, you must also permanently dedicate the organization’s assets to an exempt purpose. Your organizing documents should specify that in the event the organization dissolves, its assets will be distributed either to a specific, named 501(c)(3) organization, or to a federal, state, or local government for a public purpose.
Once you have organized as a 501(c)(3) organization, you must primarily engage only in activities that accomplish exempt purposes, as enumerated above. If more than an insubstantial part of your activities do not further an exempt purpose, your organization will be in danger of losing its tax-exempt status.
No Private Inurement
An organization which qualifies for 501(c)(3) exempt status may not be organized or operated for the benefit of private interests. This means that none of the organization’s net earnings may inure to the benefit of any private shareholder or individual, including the creator, the creator’s family, shareholders of the organization, other designated individuals, or persons controlled directly or indirectly by such private interests.
If your organization does provide an economic benefit – even indirectly – to a disqualified person, and the value of that benefit outweighs the value of their contribution to the organization, it is considered an excess benefit transaction which may be subject to excise tax. Payments from supporting organizations to substantial contributors of the organization are also excess benefit transactions. The benefit in question includes not only compensation or monetary benefit, but also an exchange of property. The tax applies to the individual, as well as to any organization managers who authorized the transaction.
No Political Campaigning
501(c)(3) organizations are prohibited from participating in any political campaigns, even indirectly. This includes contributing monetarily to a campaign, as well as public statements of position on behalf of the organization. This is a serious prohibition, and violation can result in denial or revocation of tax-exempt status as well as subjecting the organization to excise taxes.
Some non-partisan activities are permissible, depending on circumstances. For example, voter education activities and voter registration drives may be allowed, again, if they are non-partisan and do not show bias for or against any candidate or party.
In addition to the prohibition on campaigning, 501(c)(3) organizations are also limited from participating in legislative activities, known as lobbying. These organizations are not allowed to contact (or urge the public to contact) legislators to propose, support, or oppose legislation, or to urge the adoption or rejection of legislation, unless that activity is an insubstantial part of the organization’s overall activities.
This limitation is less absolute than the prohibition against political campaigning, and organizations may involve themselves in issues of public policy. You may educate the public about policy issues through educational meetings or materials.
If your organization is making any attempt to influence legislation, the IRS will consider factors such as the time and expenditures you devote to the activity. If it finds that lobbying is a substantial part of what you do in any given year, you may lose your tax-exempt status, as well as pay an excise tax of 5% of your lobbying expenditures for the year, and possibly a tax in the same amount against the organization’s managers. Private foundations may be subject to even higher excise taxes.
If your organization is not a church or a private foundation, you may elect to have your lobbying activity measured under the expenditure test instead of the substantial part test described above. This allows a small lobbying expenditure, based on the size of the organization, which will not jeopardize your tax-exempt status. In order to qualify for this test, you must file a Form 5768, Election/Revocation of Election by an Eligible IRC Section 501(c)(3) Organization to Make Expenditures to Influence Legislation. If your organization exceeds the permissible amount of lobbying in a given tax year, it is subject to excise tax of 25% on the excess. If you exceed the permissible amount for a four-year period, you may lose tax-exempt status for the entire four years, which could result in substantial taxes owed.
To obtain and retain 501(c)(3) status as a tax-exempt organization, you must be organized for an exempt purpose, not benefit any private interests, refrain entirely from political campaigning, and refrain from most lobbying.
Did you know the Colorado Nonprofit Legal Center can assist with questions you have about 501(c)(3) exemption requirements? Reach out today to ensure you protect your exempt status. You can reach us at firstname.lastname@example.org or 720-323-2720.
By Jacqueline Richards