Paying taxes is a fact of life for most small business owners. However, a few types of organizations are exempt from paying federal income taxes. And some businesses can avoid paying sales tax on certain purchases, as well.
Could your business be one of them? Here's what you need to know about becoming a tax-exempt business.
What is a tax-exempt organization?
If your business is tax-exempt, you do not have to pay federal income tax on profits. However, to qualify as a tax-exempt organization, your business must be a nonprofit organization and not generate profits with the goal of distributing those profits to shareholders or owners.
Organizations must usually apply to the IRS and meet strict requirements to be classified as tax-exempt. The type of organizations that typically qualify include:
- Religious organizations, such as churches
- Non-profit organizations, such as hospitals, labor unions, and credit unions registered as non-profits
- Organizations operating purely for the purpose of scientific research
- Historical societies and art museums
- Associations created to promote the common interest of their members, such as chambers of commerce
- Veterans' organizations in which at least 75% of their members are either serving or retired military personnel
- Organizations working for human services, such as food banks, scouts, and homeless shelters
- International organizations working for a social cause, such as the Red Cross
- Education-related organizations, such as parent-teacher associations or public schools
- Organizations working to promote horticulture or agriculture, such as forestry or crop institutes
How to apply for tax-exempt status
The IRS has four separate applications organizations can use to apply for tax-exempt status. The form you'll use depends on the type of organization.
- Form 1023-EZ, Streamlined Application for Recognition of Tax-Exemption Under Section 501(c)(3) of the Internal Revenue Code. Only organizations that exist exclusively for charitable purposes can qualify as 501(c)(3) organizations. This usually includes charitable organizations, religious organizations, and private foundations. U.S. organizations with annual gross receipts less than $50,000 and assets less than $250,000 can use this simplified application to apply for tax-exempt status with the IRS.
- Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. Charitable or religious organizations and private foundations that don't meet the requirements to complete Form 1023-EZ can apply for tax-exempt status using this form.
- Form 1024-A, Application for Recognition of Exemption Under Section 501(c)(4) of the Internal Revenue Code. Organizations that qualify for 501(c)(4) status aren't organized for profit and operate primarily to promote social welfare and benefit a community. Examples include civic leagues, local employee associations, homeowners associations, and volunteer fire companies.
- Form 1024, Application for Recognition of Exemption Under Section 501(a) or Section 521 of the Internal Revenue Code. This form is used by any nonprofit organization that doesn't qualify for 501(c)(3) or 501(c)(4) status.
As long as you have done everything right, the IRS is likely to approve your application. Normally, it takes up to 180 days to get the approval. You may contact the IRS if it is taking longer than 180 days to hear from the IRS.
Here are a few other rules to keep in mind when applying for tax-exempt status with the IRS:
- Sole proprietorships aren't eligible for tax-exempt status. You need to set up a legal business entity and register it with the relevant authorities in your state before applying to the IRS.
- It can be tough to get approved as a tax-exempt organization—especially a 501(c)(3) organization. To improve your odds, it's a good idea to consult with an attorney or tax professional to determine the type of exemption status your business may be eligible for and get help with the application.
- Even if a business is recognized as a tax-exempt organization, it may have to pay taxes on unrelated business income. This is income from a trade or business that isn't substantially related to the organization's charitable, educational, or other purposes. Exempt organizations with more than $1,000 or gross income from an unrelated business need to file Form 990-T, Exempt Organization Business Income Tax Return.
Sales tax exemptions
Federally tax-exempt entities may still have to pay sales taxes on their purchases. However, organizations may be able to avoid sales taxes by applying for an exemption certificate.
Many states tie their exemptions to the IRS rules for granting tax-exempt status.
In addition, for-profit companies that buy products for resale may be able to avoid paying sales taxes on those purchases.
In either case, organizations typically need to provide the seller with written proof that they are exempt from sales tax. For nonprofit organizations, that's usually an exception certificate from the state department of revenue. For resellers, that documentation is usually a resale certificate.
Check with your state's department of revenue or your tax advisor for guidance on applying for a sales tax exemption.
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