Is Your Business Tax Exempt?

Key takeaways

• Most tax-exempt organizations must be nonprofits with specific charitable, religious, educational, or social welfare purposes. For-profit businesses generally cannot qualify for federal income tax exemption.
• The IRS offers four main application forms (primarily Forms 1023-EZ, 1023, 1024-A, and 1024) depending on your organization type, with approval typically taking 1–8 months.
• Tax-exempt status means that there is ongoing compliance required, including annual filings and potential unrelated business income tax obligations.
• State-level exemptions for income tax, sales tax, and property tax have separate application processes and requirements that vary significantly by jurisdiction.

What is a tax-exempt organization?

A tax-exempt organization is typically a nonprofit corporation that has been officially recognized by the Internal Revenue Service (IRS) and state governments as exempt from paying certain taxes, depending on its structure, purpose, and location. These organizations must operate exclusively for specific purposes, such as charitable, religious, educational, scientific, or social welfare activities, and cannot distribute profits to shareholders or owners.

Tax exemptions generally fall into two main categories:

• Federal income tax exemption is the most comprehensive, applying to organizations that meet IRS requirements under Section 501(c) of the Internal Revenue Code. 
• State and local tax exemptions allow qualifying organizations to purchase goods and services without paying state sales tax, may reduce or eliminate property tax obligations, and may not require state income tax payments, though requirements vary significantly by state and jurisdiction. 

Tax-exempt status is not automatic and requires a formal application and approval. The organization must demonstrate that it meets specific criteria, maintains proper governance structures, and operates within the bounds of its exempt purpose. Additionally, even tax-exempt entities may owe taxes on unrelated business income (UBI) that doesn't directly support their exempt purposes.

Who qualifies for tax-exempt status?

Qualifying for tax-exempt status requires meeting specific organizational and operational criteria established by federal and state tax authorities. 

Federal tax exemption categories

The IRS recognizes numerous categories of tax-exempt organizations under Section 501(c) of the Internal Revenue Code, each with distinct requirements and limitations:

• 501(c)(3). Charitable organizations, religious institutions, public safety and educational organizations, scientific research organizations, and private foundations; can receive tax-deductible donations from supporters.
• 501(c)(4). Organizations focused on social welfare and civic improvement, including civic leagues, homeowners associations, and volunteer fire departments; charitable contributions to these organizations are generally not tax-deductible for donors 
• 501(c)(5). Labor and agricultural organizations
• 501(c)(6). Business leagues, including chambers of commerce, boards of trade, real estate boards, and professional football leagues
• 501(c)(7). Social and recreational clubs
• 501(c)(19). Veterans organizations

State-specific considerations

State tax exemption requirements often align with federal standards but can include additional criteria or limitations. For example, some states, like California, require organizations to register separately for state income tax exemption even after receiving a federal exemption. Many states automatically grant state income tax exemption to organizations that have obtained federal 501(c)(3) status, though they may require a notification or simple filing. Other states grant limited sales tax exemptions to specific types of 501(c)(3) nonprofits while maintaining strict requirements for documentation and compliance, often requiring organizations to apply for and obtain a specific sales tax exemption certificate.

Religious organizations often receive special consideration, with most states providing exemptions for property used exclusively for religious worship. However, commercial activities or rental properties owned by religious organizations may not qualify for the same exemptions, requiring careful evaluation of each property's use and charitable purpose.

How to apply for federal tax-exempt status

Qualifying for 501(c)(3) tax exemption begins with proper business formation and continues through federal and state applications. The process can take several months to complete and requires careful attention to documentation, timing, and ongoing compliance requirements.

Step 1: Form a legal entity in your state

Before applying for tax exemption, you must form a legal nonprofit entity, such as a corporation or trust, in your state of operation. Generally, sole proprietorships cannot qualify for federal tax exemption, while limited liability companies (LLCs) can qualify, but they face specific structural requirements outlined by the IRS that make the process more complex than for a nonprofit corporation. Your organizing documents (articles of incorporation or trust agreement) must include specific language about your exempt purposes and restrictions on private benefit or political activities.

The organizing documents should clearly state your organization's charitable, religious, educational, or other exempt purpose using language that aligns with IRS requirements. Include provisions that prohibit private inurement (personal benefit to insiders), limit political campaign activities, and specify how assets will be distributed if the organization dissolves. 

Step 2: Choose the appropriate IRS application form

The IRS provides four main application forms for tax-exempt status, and selecting the correct form depends on your organization type and size:

• Form 1023-EZ offers a streamlined application process for small 501(c)(3) organizations with annual gross receipts under $50,000 and assets under $250,000. This simplified form typically receives faster processing but has strict eligibility requirements and may not be suitable for complex organizations. Organizations must use the Form 1023-EZ Eligibility Worksheet to determine if they qualify.
• Form 1023 serves as the comprehensive application for 501(c)(3) status when organizations don't qualify for the EZ version or prefer the more detailed review process. This form requires extensive documentation, including detailed descriptions of activities, financial projections, and governance policies. 
• Form 1024-A applies specifically to 501(c)(4) social welfare organizations.
• Form 1024 covers all other nonprofit categories under Section 501(c).

Step 3: Prepare required documentation

Successful applications require comprehensive documentation that demonstrates your organization's charitable purpose, governance structure, and operational plans. Essential documents include your articles of incorporation or trust agreement, bylaws, conflict of interest policy, and detailed descriptions of planned activities and programs. Financial information must include projected budgets for at least three years, funding sources, and explanations of how funds will be used to advance your exempt purposes.

The IRS also requires information about your organization's leadership, including board members' qualifications and any compensation arrangements. If your organization plans to engage in activities that might generate UBI, you'll need to explain these activities and demonstrate how they support your exempt purposes. 

Professional assistance from attorneys or tax professionals who are experienced in 501(c)(3) nonprofit formation can improve your application's chances of approval.

Step 4: Submit application and await determination

The IRS notes that applicants must register for an account on Pay.gov to fill out and submit the form. Once your application is complete, submit it to the IRS along with the required filing fee, which varies by form. The IRS approves or denies applications typically within 1–8 months. You can check current application processing times on the IRS website. During this period, the IRS may request additional information or clarification, so respond promptly to any correspondence to avoid delays.

If approved, you'll receive a determination letter confirming your status, which you'll need for various purposes, including state tax exemption applications, grant applications, and donor verification. If your application is denied, you have the right to appeal the decision or reapply with additional information addressing the IRS's concerns.

State-specific tax exemption considerations

State-level tax exemptions operate independently from federal tax-exempt status and require separate applications and ongoing compliance. While many states recognize federal status determinations as a starting point, each state maintains its own requirements, limitations, and application processes.

State income tax exemption

To be eligible for a state income tax exemption, organizations must comply with their state’s requirements. In some states, like California, tax-exempt organizations must submit a separate application to the state tax board. Other states make this automatic if the business obtained a federal exemption, though they may still require a notification filing or copy of the IRS determination letter.

Sales tax exemption

This type of exemption allows qualifying organizations to purchase goods and services without paying state sales tax, potentially resulting in significant cost savings. Most states require organizations to apply for an exemption certificate or number that must be provided to vendors at the time of purchase. The application process typically requires proof of federal tax-exempt status, detailed descriptions of how purchased items will be used, and sometimes additional documentation about the organization's activities.

For example, in Georgia, qualifying nonprofit organizations must complete specific forms and provide their IRS determination letter, articles of incorporation, and detailed explanations of their exempt activities. The state grants exemptions to licensed hospitals, private schools serving grades K-12, nonprofit food banks, and other specifically enumerated organization types. However, the exemption may be limited to purchases directly related to the organization's exempt purposes, with personal or unrelated business purchases remaining taxable.

Some states also provide exemptions for specific types of sales made by exempt organizations, like religious institutions or parent-teacher organizations. Understanding these nuances requires careful review of your state's specific regulations. 

Property tax exemption

Property tax exemptions are typically administered at the county or municipal level, though state laws establish the framework and eligibility criteria. All states provide some form of property tax exemption for religious, charitable, and educational organizations. Most jurisdictions require that property be used exclusively for exempt purposes, meaning any commercial use or rental to non-exempt entities may disqualify the entire property or require partial taxation.

The application process usually involves filing annual claim forms or applications with the local tax assessor, providing detailed information about property use, and demonstrating continued compliance with exemption requirements. Some jurisdictions require periodic renewals or reviews, while others grant exemptions that continue until the property use changes. 

Organizations should be aware that property tax exemptions can be retroactively revoked if the property use changes or if the organization loses its underlying tax-exempt status. This makes ongoing compliance monitoring essential, particularly for organizations with significant real estate holdings or those considering changes to property use.

Maintaining tax-exempt status

Preserving tax-exempt, nonprofit status requires ongoing attention to compliance obligations, proper record-keeping, and adherence to operational restrictions. Businesses that fail to meet these requirements risk losing their exemption, facing penalties, or owing back taxes that can threaten the organization's mission effectiveness and financial stability.

File annual returns

Most tax-exempt organizations must file annual information returns with the IRS, even though they don't owe income tax. Find out which form your organization needs to file.

There are financial penalties for late filings. Additionally, organizations that fail to file required returns for three consecutive years automatically lose their status. 

State filing requirements vary but often include annual reports, charitable solicitation registrations, and specific disclosures about activities within the state. Maintaining a compliance calendar and working with qualified professionals can help ensure that all deadlines are met.

Track and report unrelated business income (UBI)

Even tax-exempt organizations may owe taxes on UBI, which is income from activities that don't substantially relate to the organization's exempt purposes. Common examples include rental income from debt-financed property, advertising revenue, and sales of goods or services that compete with for-profit businesses.

Organizations with gross UBI exceeding $1,000 in any tax year must file Form 990-T and pay taxes on that income at corporate tax rates. This requirement applies regardless of whether the organization uses UBI proceeds to support its exempt activities. 

The IRS provides several exceptions to UBI rules. However, these exceptions have specific requirements and limitations that require careful analysis. Organizations should regularly review their revenue sources and consult with tax professionals to ensure compliance and optimize their tax position.

Avoid compliance errors

One of the most serious mistakes that tax-exempt businesses can make involves private inurement or private benefit violations, where organizational resources improperly benefit insiders or private parties. This can include excessive compensation to executives, below-market transactions with board members, or using organization assets for personal purposes. Even inadvertent violations can jeopardize status, making clear policies and regular monitoring essential.

Political campaign activity represents another high-risk area, particularly for 501(c)(3) organizations that face absolute prohibitions on supporting or opposing political candidates. While these organizations can engage in limited lobbying activities, they must carefully track and limit such activities to avoid exceeding IRS thresholds. Organizations should establish clear policies distinguishing between permissible issue advocacy and prohibited campaign intervention.

Failure to maintain proper governance structures and documentation creates ongoing compliance risks. This includes holding required board meetings, maintaining meeting minutes, updating bylaws as needed, and ensuring board oversight of key decisions. Make sure to properly document board decisions about compensation, conflicts of interest, and major transactions.

Tax-exempt business FAQs

What types of organizations qualify for tax exemption?

Tax-exempt status is primarily available to nonprofit organizations that serve charitable, religious, educational, scientific, or social welfare purposes—not private interests. The most common categories include 501(c)(3) charitable organizations, like church-affiliated organizations, private foundations, schools, nonprofit hospitals, and charitable foundations, as well as 501(c)(4) social welfare organizations, such as civic leagues and homeowners associations. Other qualifying entities include labor unions, business leagues, social clubs, and even nonprofit credit unions. 

For-profit businesses generally cannot qualify for federal income tax exemption, though they may be eligible for specific sales tax exemptions in certain circumstances.

Can an LLC be tax exempt?

Limited liability companies (LLCs) can potentially qualify for tax-exempt status, but they face significant challenges and limitations. The Internal Revenue Service generally requires entities with this status to be organized as corporations or trusts, and LLCs must meet additional requirements, including having only tax-exempt entities as members and operating exclusively for exempt purposes. 

Most tax professionals recommend forming a 501(c)(3) nonprofit corporation instead of an LLC when seeking tax-exempt status, as the corporate structure provides clearer compliance pathways and broader acceptance by regulators and donors.

How long does it take to get tax-exempt status?

The IRS typically takes 1–8 months to process tax-exempt applications. The time it takes to get confirmation of status depends on the form you submit, as each form has different processing times. Businesses can request to expedite processing in writing.

Do tax-exempt organizations pay sales or property tax?

Tax-exempt status from federal income tax doesn't automatically exempt organizations from state and local taxes. Sales tax exemptions may require separate applications to state revenue departments or tax boards and are often limited to purchases directly related to the organization's exempt purposes. Property tax exemptions are often administered locally and typically require that property be used exclusively for exempt activities. Many states provide sales tax exemptions for qualifying nonprofits, but requirements vary significantly by jurisdiction and organization type.

What happens if a tax-exempt organization earns unrelated business income?

Tax-exempt organizations must pay federal income tax on unrelated business income (UBI) that exceeds $1,000 annually, even while maintaining their overall exempt status. Organizations must file Form 990-T and pay corporate tax rates on UBI. However, several exceptions exist, including income from volunteer-conducted activities, sales of donated goods, and certain rental income. 

What is a resale certificate and who can use it?

A resale certificate allows businesses to purchase goods for resale without paying sales tax at the time of purchase, with the understanding that the tax will be collected when the goods are sold to end consumers. This is different from nonprofit tax exemptions and is available to for-profit businesses engaged in retail activities. Resale certificates require registration with state tax authorities and can only be used for goods that will be resold in the ordinary course of business. Misuse of resale certificates can result in penalties and back tax assessments.

Is tax-exempt status recognized in all states?

Federal tax-exempt status provides a foundation for state-level exemptions, but each state maintains its own requirements and limitations. While most states recognize IRS determinations as qualifying organizations for consideration, they may impose additional requirements, limit exemptions to specific activities, or require separate applications. Some states automatically grant certain exemptions to federally recognized organizations, while others require detailed state-specific applications. Organizations operating in multiple states must research and comply with each jurisdiction's requirements separately.

What happens if you lose tax-exempt status?

Losing tax-exempt status can have severe consequences, including owing back taxes, losing eligibility for grants and tax-deductible charitable contributions, and facing penalties for late filing. In some cases, organizations can apply for reinstatement by correcting violations and paying the required fees. However, prevention through proper compliance monitoring is far preferable to attempting reinstatement after losing exempt status.

Are all nonprofit organizations tax exempt?

Not all nonprofit organizations automatically qualify for tax-exempt status. While nonprofit incorporation at the state level is often a prerequisite for tax exemption, it doesn't guarantee IRS approval. Organizations must separately apply for federal tax-exempt recognition and meet specific operational and organizational requirements. Some nonprofits may qualify for state-level exemptions without federal recognition, while others may operate as nonprofits without any tax exemptions. The terms "nonprofit" and "tax-exempt" are related but distinct legal concepts.

How LegalZoom can help tax-exempt businesses

Ready to start your nonprofit? LegalZoom provides comprehensive support for organizations seeking tax-exempt status, from initial entity formation through ongoing compliance management. 

Our business formation services can help you choose the appropriate business structure, prepare and file IRS applications, develop required governance policies, and maintain compliance with federal and state requirements. Our network of experienced attorneys and tax professionals can guide you through the complex application process, help avoid common pitfalls, and provide ongoing support to maintain your exempt status.

We also offer compliance tools and resources to help you stay current with changing regulations and filing requirements, ensuring that your organization can focus on its mission while meeting all legal obligations.

Janet Berry-Johnson contributed to this article.