Groups can organize as nonprofits without obtaining a special tax status, but obtaining 501(c)(3) tax-exempt status from the Internal Revenue Service allows an organization’s donors to deduct a portion of their contributions from their personal taxes. Exempt organizations, or charitable organizations, must be organized and operated exclusively for one of the exempt purposes listed in section 501(c)(3) of the Internal Revenue Code. Purposes include charitable, religious, educational, scientific and literary pursuits, and can include such diverse activities as testing for public safety, fostering amateur sports competitions, and preventing cruelty to children or animals. An organization must file Form 1023 to officially receive IRS tax-exempt status.
Once an organization obtains 501(c)(3) status, it must comply with IRS rules to keep its tax-exempt status. Though nonprofits are not prohibited from earning an income, none of those earnings can go to the benefit of any person. This means that, unlike a for-profit corporation, a nonprofit cannot give its earnings to someone like a shareholder or owner as profit. For example, a nonprofit entity that earns $100,000 of income in a year but only has $75,000 of expenses does not lose its tax-exempt status if it keeps that money in the organization to be spent later. If, however, it distributes that money among its shareholders, it may lose its status.
Related Vs. Unrelated Activities
Though nonprofits can earn money without paying taxes on their earnings, that general rule does not apply to “unrelated” business income. Unrelated income, as defined by the IRS, is income from a regularly conducted trade or business that is not substantially related to the organization’s exempt purpose. Income is not considered related simply because the organization uses it to support its exempt purpose. For example, a nonprofit child care facility that also sells T-shirts to raise money may have to pay taxes on income from the sales if those sales are regularly conducted, or frequent and continuous, and pursued in a manner similar to the way a for-profit business operates. Nonprofits must report unrelated income over $1,000 on Form 990-T and pay taxes at the corporate tax rate.
Many types of fundraising activities do not trigger the requirement to pay taxes. For example, nonprofits can receive government grants or private donations to fund their operations. Organizations like food banks can take donations in the form of nonperishable food and redistribute those items to the beneficiaries they serve. Other nonprofits operate on a fee-for-service basis, meaning beneficiaries pay a fee for a service the nonprofit provides. These fees may not cover the entire cost of the service, but the nonprofit can use the money to supplement other sources of income. For example, a nonprofit child care center may charge the parents who bring their children to the center, but it may also solicit additional donations or grants to cover expenses.