Nonprofit organizations with tax-exempt status are big business in the U.S. In 2021, 1.9 million tax-exempt organizations were employing around 12 million people—about the same as the manufacturing sector at the time.
The nonprofit sector is unique in that it is composed of organizations pursuing a vast range of different activities and goals, from universities and hospitals to religious organizations and charitable organizations.
"There are certain type of orgs that you'll regularly see coverage of—food banks, Habitat for Humanity, or YMCA, or YWCA—but there are millions of nonprofit organizations in the country, and they're all doing different things and helping different people in different ways," says Rick Cohen, the chief communications officer and chief operating officer at the National Council of Nonprofits.
With so much diversity among the sector's organizations, what makes them all alike? Is it all about maintaining tax-exempt status, or are there other factors beyond the internal revenue code? In short, what exactly defines nonprofit status?
For those considering pursuing federal tax exemption, it is important to understand the answer to this question. Nonprofit status comes with some distinct advantages as well as a variety of limitations.
How to get nonprofit status
Nonprofit corporations have several unique characteristics that differ from those of for-profit corporations, as defined by the federal government. Some of these are extremely impactful in terms of how nonprofit organizations must behave and what benefit can accrue to the individuals involved in the organization.
Nonprofits have no owners
A key characteristic of nonprofit status is that, unlike a private business, a nonprofit has no owners. This is because a nonprofit organization belongs to the public, in line with its purpose to be of public benefit. When a nonprofit dissolves, its assets must be given to another nonprofit or religious organization or be used for charitable purposes. If the nonprofit's assets are misapplied or used for private benefit by the organization's officers or board members, the state attorney general's office or government agencies can seize them.
"In order to get the tax-exempt status, nonprofits have to have limiting language in their governing documents that says nobody has an ownership interest," says Shirley McLaughlin, the principal at Adler & Colvin, a law firm specializing in tax-exempt organizations. "No directors or officers can get paid out and walk away—for example, if the nonprofit dissolves or sells its assets."
One exception to this rule is a type of nonprofit organization called a mutual benefit corporation that can be created in certain states, wherein members pay dues or membership fees. The members have a similar official status to stockholders in that they may be eligible to receive some of the corporation's assets upon its dissolution.
Nonprofits must reinvest profits
Just like businesses, a nonprofit company generates revenue in many ways. While donations and grant funds account for some of that income, organizations bring in far more money in other ways: by providing services, selling products, fulfilling government contracts, and doing other income-generating activities. A unique characteristic of nonprofit status is that according to the Internal Revenue Code, all profits must be returned to the organization instead of paying them out to owners or shareholders as companies do.
"'Nonprofit' is not the best description," says Cohen, whose organization is a nonprofit. "We need to make a profit. We need to be able to put away money for a rainy day. We need to be able to expand programs. But all those profits have to stay in the organization."
Nonprofits status means special federal income tax treatment
Many nonprofits may be exempt from paying many taxes, including state sales tax, property tax, and income tax, as well as local taxes—a favored status that is often referred to as tax-exempt status. Tax-exempt entities may also have tax exemptions from federal income tax, but federal tax-exempt status is not granted automatically. The organization must officially apply for a federal income tax exemption from the IRS and be granted this status via an IRS determination letter.
The details of tax-exempt status depend on what type of nonprofit the entity is. Many nonprofits are public charities, otherwise called 501(c)(3) organizations, after the part of the internal revenue tax code in which they are defined. A 501(c)(3) can accept donations, and donors get a “contribution deduction" on their taxes, meaning their donations are exempt from income tax. Non-501(c)(3) types of nonprofit entities are not eligible for tax-deductible contribution deductions.
It's a misconception that nonprofits with “tax-exempt status" are exempt from all taxes, Cohen says. "One advantage is the exemption from some taxes—'some' being emphasized. We're not fully tax-exempt. We pay employment taxes."
Nonprofits face limits on their activities
Maintaining tax-exempt status means a nonprofit organization can only perform certain functions listed in federal tax exemption laws. If it goes outside those limits, the nonprofit may have to pay taxes on some of its income, pay penalties, or lose its tax exemption entirely.
A unique characteristic of nonprofit status is that according to the Internal Revenue Code, all profits must be returned to the organization.
The most common type of nonprofit entity, the 501(c)(3), must have a charitable purpose and be operated exclusively to fulfill that charitable purpose. Other types of nonprofits can direct benefits to a more specific group of individuals, such as their own members. Examples are labor organizations and unions (501(c)(5) organizations), social organizations like country clubs and community groups (501(c)(7)), and chambers of commerce (501(c)(6)).
“In exchange for [tax-exempt status] and the added benefit of tax-deductible contributions, 501(c)(3)s come with the most restrictions," McLaughlin says. “They can't provide more than incidental private benefit to anybody. Everything they do has to benefit the general public or particular needy groups."
All 501(c)(3) organizations are prohibited from engaging in electioneering, such as working on a political campaign and from doing “substantial lobbying." Private foundations, a type of 501(c)(3), are barred from doing any lobbying, while public charities can do some minor amount of lobbying to advance their cause. Other types of nonprofits can be politically involved. A 501(c)(4) nonprofit, typically called a "social welfare" organization, is allowed to engage in unlimited legislative lobbying.
Cohen says nonprofits cannot do any lobbying is another misconception. "We can lobby, we can advocate. There are limitations on those activities, but they don't stop organizations from being able to speak up to further their mission."
Nonprofits are subject to public scrutiny
Another distinct characteristic of nonprofit status is being subject to public scrutiny. Because a nonprofit organization is dedicated to the public, its finances are open to public inspection. Copies of the nonprofit's recent tax returns (Form 990 or 990-EZ) are made available to the public by state and federal tax authorities.
Additionally, to maintain tax-exempt status under IRS regulations, a nonprofit organization must provide any individual members of the public who requests it with a copy of its application for tax exemption (Form 1023 or 1024), which includes the articles of incorporation. The nonprofit organization can charge a reasonable fee for copying and delivering these to the requester.
"In general when I'm counseling somebody about whether they want to start a new charity, public scrutiny is something I'm talking people through," McLaughlin says. "Financial statements have to be made available to the public upon request under the laws of some states."
Public charities—a type of 501(c)(3)—must file the most thorough tax documents compared to other nonprofit organizations.
"The reporting requirements for charities are through the roof compared to other tax-exempt organizations," McLaughlin adds. "Public charities have higher disclosure standards. Donors can get better deductions, so the idea is that the public keeps those charities accountable. That accountability is theoretically possible due to a very in-depth public Form 990 tax return."
How to decide whether nonprofit status is right for you
Innovators, entrepreneurs, and others often have ideas for projects or enterprises that they want to turn into legal entities, whether a for-profit corporation or a nonprofit organization. In some cases, such as for projects directed toward helping others or enhancing the public good, pursuing the tax-exempt status of a nonprofit may seem like the logical thing to do. But it's a good idea to think carefully about whether this classification is the right match for your plans.
Start by looking at the benefits and limitations of nonprofit status, as they are part and parcel of this type of entity. You only get the benefits because you are willing to accept the limitations.
The advantages of nonprofit tax status
The biggest advantage of nonprofit status is tax-exempt status, or more accurately, the exemption from some state and federal income tax and other taxes. "It does help being able to put those resources into the organization and help as many people as possible," Cohen says. Those pursuing 501(c)(3) status also benefit from tax-deductible contribution rules, which encourage donations.
Nonprofits have a special place in society, and the goodwill people typically feel about altruistic activities can help these organizations pursue priorities and get resources that companies cannot access.
Discounts and donations
Nonprofits get discounts on many things, including valuable products and services from large companies that want to give back. They can also accept donations from individuals who want to help via fundraising activities, as well as pursue grants from foundations and government agencies. This financial assistance makes it easier to make ends meet and create a positive impact on society.
Easy recruitment of caring workers
Nonprofits and private foundations are typically seen as good for society. This reputation can help attract workers who care deeply about an organization's mission. People with a proclivity for public service may find a better fit at a nonprofit than at a for-profit that has a social-good component. Additionally, the federal government's Public Service Loan Forgiveness (PSLF) program, which forgives student loan debt after a borrower has worked in the nonprofit sector for 10 years, helps attract candidates.
The limitations of nonprofit status
Lack of ownership
Founding a nonprofit organization makes you a founder, but not an owner, since nonprofit entities are, by definition, owned by the public. This may feel like a limitation on several fronts. You will not be able to call the shots in the way the owner of a company can. You will also not receive any profits that the organization makes, as they must be reinvested in the organization. And in most cases, you will not be able to recoup any profit upon the dissolution of the organization.
Limitations on activities
Nonprofits have many limitations on what they can do and how they can behave—particularly limitations on political activity. Obeying those strict guidelines is the price organizations and private foundations pay to obtain and keep the tax-exempt status they benefit from. When considering tax-exempt status, think carefully about what activities you will want to engage in, who will benefit from those activities, and whether the limitations that nonprofit status entails are worth the benefits.
Public disclosure requirements
Tax-exempt status limits the decisions you can make regarding what financial and other information to share with the public. If you choose nonprofit status, be comfortable having your tax returns and other documentation available to all.
Inability to recoup value
Assets owned by nonprofits cannot ever revert to private ownership, regardless of whether they have increased in value over time. If you are developing a piece of intellectual property, such as a software or training program, be aware that obtaining nonprofit status to develop it will forestall any future ability to use it in other ways. It will also prevent you from ever cashing in on the increase in value if the product becomes a success.
"Where you're building value is hugely important," McLaughlin says. "Once you build or put an asset in a charity, it can't come out, or it can only come out in very limited scenarios."
An alternative option is to start a for-profit entity to develop the product or service and establish a relationship with a charitable program. The for-profit can provide use of that product or service for a discount or for free so the partner organization can carry out its charitable purposes, McLaughlin advises. "Now, if that platform becomes highly valued, you could make money off it while still using it for a charitable purpose."
Potential for loss of tax-exempt status
A nonprofit organization might lose its tax-exempt status if it doesn't fulfill its responsibilities, such as timely filing of regular tax returns and other reporting. McLaughlin provides the example of a nonprofit founder who had cancer and forgot to file tax returns for a few years, which prompted the IRS to revoke the organization's tax-exempt status. Getting the tax-exempt status reinstated was a major project and is not something a for-profit entity would have to worry about. A company that neglects to file tax returns simply accrues taxes and penalties. But “for nonprofits, little things like that will cause big headaches," according to McLaughlin.
Make sure it's for the public good
If you are considering whether to pursue tax-exempt status as an official nonprofit, before applying for nonprofit status focus most strongly on your intent. Is your main priority helping others or solving a societal problem? Will that be your priority for years to come, and are you willing to forgo profits for that goal?
The point of nonprofit status is to allow entities to more effectively help others or solve social problems, and those who work in the sector find being involved in that project very gratifying.
“It's nice being part of a sector that's making such a difference in the world and helping people in ways seen and unseen," Cohen says.
McLaughlin agrees. "I really love working with nonprofits because I feel like they're the place to interact directly with the people who need help the most and are solving problems on the ground every day," she says.
If your goal is to pursue social good, look at the benefits and limitations of nonprofit status to see if that option is the best tool at your disposal.
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