Taxes represent a substantial portion of business expenses, but certain nonprofit businesses can enjoy tax-exemption under section 501(c)(3) of the Internal Revenue Code. Any business seeking this kind of tax-exempt status must be organized for a nonprofit purpose recognized by the Internal Revenue Service (IRS). You can convert your existing business to a nonprofit or you can create one from the start. There are two main types of 501(c)(3) organizations.
One acceptable type of nonprofit under the IRS Code is a public charity. When most people hear 501(c)(3), this is the type of organization they envision. People organize these businesses for a purpose recognized by the IRS as being a benefit to the community and can receive tax-exempt status. These charities are wide-ranging but can include:
- Research centers
- Homeless shelter
- Donation centers
Churches are automatically tax-exempt when they begin operating, but other charities must register before they receive tax-exempt status. All public charities receive money and other contributions from multiple sources. These donations from the public are tax deductible for the donor.
The other type of nonprofit that can receive tax-exempt status is a private foundation. These organizations receive private funding in the form of investments and endowments to operate a business for a tax-exempt purpose, such as a museum. Private foundations differ from public charities in one key way: these organizations rarely receive money and donations from multiple sources. This allows for more control.
Private foundations can also focus on grants. These types of tax-exempt organizations give money to public charities or to individuals in the form of scholarships or grants. These, too, can receive contributions from the public or from a single source. Many grant-focused private foundations are controlled by a family, providing support for a tax-exempt purpose, such as the Bill and Melinda Gates Foundation.
The IRS requires all private foundations to distribute a minimum of 5% of their net investment assets for a recognized charitable purpose. This can take the form of a donation to a public charity or for the foundation's own charitable purpose. The distribution, however, must come out of the foundation and not be an asset.
Gaining Status as a 501(c)(3) Organization
Understanding the key differences between a public charity and a private foundation can help you determine which path is correct for your business. Regardless of the direction you choose, make sure you understand the requirements for applying for status as a 501(c)(3) organization.
Applying for tax-exempt status does not mean you will receive it. Failing to provide accurate information to the IRS can delay your application and registration and can lead to your organization paying fines. It could even completely prevent your business from receiving tax-exempt status.
Each type of tax-exempt business has its own benefits and responsibilities. Both require careful maintenance and complying with IRS rules and regulations. By understanding the differences, you can choose the right 501(c)(3) organization for your business.
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