Maintaining Tax Exempt Status in a Nonprofit by Jonathan Layton, J.D.

Maintaining Tax Exempt Status in a Nonprofit

Play by the rules or risk losing your organization's highly sought after tax-exempt status.

by Jonathan Layton, J.D.
updated September 16, 2020 · 4 min read

Obtaining nonprofit, tax-exempt status is a feat in and of itself. But maintaining that status can be equally onerous. The consequences of failing to do so are severe.

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Starting a Nonprofit and Obtaining Tax-Exempt Status

Section 501(c)(3) of the Internal Revenue Code (IRC) provides nonprofit organizations an exemption from paying federal income tax. Nonprofits typically include charitable, religious, literary, scientific, public safety, and educational organizations.

The general requirement to qualify as a nonprofit is that the organization offers services that benefit the public at large.

However, unless and until a nonprofit files an application under IRC Section 501(c)(3) and receives tax-exempt status from the IRS, the organization will be required to pay federal income taxes.

Some of the steps involved in obtaining an exemption from paying federal income tax as a nonprofit include:

  • Conducting research of the applicable IRC provisions and become familiar with the steps involved in creating a nonprofit, tax-exempt organization
  • Developing a comprehensive business plan for the organization
  • Preparing and filing the necessary 501(c)(3) nonprofit formation documents (and obtaining an Employer Identification Number)
  • Obtaining approval from the IRS to receive an exemption from paying federal income taxes

How to Maintain Your Tax-Exempt Status

Maintaining your nonprofit's tax-exempt status under IRC 501(c)(3) requires you to constantly keep up with a number of routine tasks including, but not limited to:

  • Establishing a corporate board. All nonprofits must elect officers and appoint a board of directors. Board members attend regular meetings to oversee the nonprofit's proper functioning, cast votes on important issues related to the organization, and generally act in the organization's best interests. The board's major actions or decisions are typically accomplished by way of a corporate resolution and are recorded in a minute book.
  • Having a purpose. When a nonprofit applies to the IRS for tax-exempt status, the organization must clearly set forth the entity's intended scope and purpose. Once the IRS approves the scope and purpose, the nonprofit must continually operate the entity within those stated parameters. So, for example, if the nonprofit represents to the IRS that the entity's purpose is to operate a youth sports organization, it cannot suddenly decide instead to operate a parent/teacher organization. If the nonprofit strays from the scope and purpose for which the tax-exempt status was issued, the IRS can nullify the tax exemption altogether or reclassify the organization as a private entity (in which case, federal taxes would need to be paid).
  • Documenting any donations received. If your nonprofit organization engages in fund-raising activities and solicits donations from the public, you must be prepared to provide a receipt or some form of written acknowledgment to individuals who donate more than $250 so that the individuals may apply for a year-end tax deduction. In the event an individual provides goods or services in lieu of tendering a financial contribution, the IRS requires the nonprofit organization to estimate the fair market value of those goods or services and disclose that information on the donor's receipt.
  • Adhering to an approval process for contracts and other agreements. All activities of your nonprofit organization are intended to benefit the interests of the public (as opposed to private interests). Anytime an agreement is entered into between your organization and any individual who is in a position to exert influence over the organization, the individual's interest must first be revealed to the board of directors and then approved by the board. In all cases, the agreements must be deemed "commercially reasonable," and cannot exceed the fair market value of the typical cost of the trade or service being provided.
  • Understanding lobbying laws. It is imperative for all nonprofit organizations to have a working knowledge of (and strictly adhere to) the fairly complex set of local, state and federal restrictions and registration requirements related to lobbying activities. In general, an organization may participate in lobbying activities. However, the activities cannot make up a significant part of the nonprofit's routine activities, nor can they be in excess of a certain percentage of the nonprofit's gross receipts.
  • Avoiding all political campaign activities. All nonprofit organizations are strictly forbidden from participating in any event or activity that favors or endorses a particular candidate for political office. This includes donations to a candidate's campaign.
  • Paying taxes on unrelated business income. All 501(c)(3) organizations are required to pay state and federal taxes on "unrelated business income," meaning income generated from activities that are unrelated to the nonprofit's tax-exempt purpose. Unrelated income, which exceeds $1,000 annually, represents taxable income and must be included in the nonprofit's annual tax return (Form 990-T) and paid to the IRS.
  • Filing annual information returns. Most, but not all, 501(c)(3) organizations are required by the IRS to file an annual information return, setting forth the organization's income, expenses, and regular activities. Nonprofit organizations whose gross receipts exceed $50,000 must file an annual federal income tax return. By the same token, nonprofits with gross receipts equaling $50,000 or less must file a tax-exempt form (Form 990-N).

What Happens In the Event of Noncompliance?

If the nonprofit organization fails to follow the rules, regulations, and formalities outlined above, the IRS can levy a special excise tax upon the nonprofit.

Even worse, noncompliance can cause the nonprofit to lose its nonprofit status altogether.

 

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Jonathan Layton, J.D.

About the Author

Jonathan Layton, J.D.

Jonathan Layton is a graduate of The College of  William and Mary, where he majored in English literature. While in coll… Read more