October 25, 2023
By Richard J. Locastro, CPA, JD and Katelyn Miller, CPA, MST
The terms “nonprofit” and “tax-exempt organization” are often used interchangeably. And while there may be considerable overlap in their definitions, there is a distinction, especially for a 501(c)(3) public charity or private foundation. As explained further below, the process to become a tax-exempt organization begins with forming a nonprofit organization. A 501(c)(3) organization must apply to be tax-exempt, and this article will discuss the steps organizations should follow to receive tax-exempt status.
Step One – Forming a Nonprofit Organization
The first step is to legally form the nonprofit organization under state law. Often, the organization will be formed as a corporation, but nonprofit organizations may be organized as a trust or other association. Forming a nonprofit corporation will often include not only the filing of articles of incorporation with a state but also appointing of directors and drafting of by-laws.
When filing articles of incorporation, the choice of state may be important for many reasons, including state rules governing the formation and operation of charities and financial statement audit or review requirements. Collaborating with legal counsel in tandem with your CPA firm can provide the necessary guidance on these issues.
Step Two – Applying for Tax-Exempt Status
Once the nonprofit organization is properly organized under state law, it should begin the process of applying for tax-exempt status with the Internal Revenue Service (IRS). To do this, the organization must first obtain an Employer Identification Number (EIN), a unique identifier for your nonprofit needed for various purposes, including filing tax returns. You can obtain an EIN by completing Form SS-4, which can be found on the Internal Revenue Service (IRS) website. The EIN must be obtained before the nonprofit can file to apply for tax-exempt status.
501(c)(3) Organizations
For a 501(c)(3) organization, the application for federal tax-exempt status is initiated by preparing and filing Form 1023 or 1023-EZ. Form 1023 or 1023-EZ must be filed within 27 months after the end of the month in which the organization was legally formed for the exemption to be retroactive to the date of formation. Form 1023-EZ is a shorter form that may often receive approval faster than filing Form 1023, however; it can only be used by organizations that, among other things, do not project annual gross receipts to exceed $50,000 in the next three years. For more information consult the “Form 1023-EZ Eligibility Worksheet” in the Form 1023-EZ instructions. Organizations that do not qualify for Form 1023-EZ filing must file Form 1023.
Form 1023 requires that the organization detailed information about the organization’s activities, governance, finances, and purpose. The submission, which must be done electronically, includes financial information or projections, copies of articles and bylaws, conflict of interest policies and other supporting documents.
501(c)(4) and 501(c)(6) Organizations
Other tax-exempt organizations such as 501(c)(4)s or 501(c)(6)s should file Form 1024-A or Form 1024, respectively to be recognized as tax-exempt by the IRS. Different from 501(c)(3)s, these organizations may also “self-declare” their exempt status. In other words, these organizations do not have to file an application for exemption (Form 1024-A or 1024) to become tax-exempt. 501(c)(4) organizations must now file Form 8976 Notice of Intent to Operate Under Section 501(c)(4), within 60 days of formation.
Paying User Fees
When filing the Form 1023, 1023-EZ or 1024-A or Form 1024, organizations should be sure to pay the applicable user fee. The fee amounts vary depending on the type of exemption sought and the size of the organization. Consult the instructions accompanying the form for the current fee schedule.
Step Three – IRS Approval
After the appropriate form has been completed, the organization must wait for the IRS to process the application. The IRS will review your application and may request additional information or clarification if needed. Processing times can vary, but you can generally expect a response within several months. Information on the expected timing and current IRS processing status can be obtain on the IRS website page, Where’s My Application for Tax-Exempt Status?
While waiting for approval of tax-exempt status, the nonprofit is not required to delay tax-exempt activities. The organization may conduct operations consistent with its mission unless it is able to self-declare its tax-exempt status (as discussed above), but it should be careful not to represent that it has had its tax-exempt status approved by the IRS. This is particularly important for 501(c)(3) organizations who receive contributions. Until IRS approval of tax-exempt status as a 501(c)(3) organization is received, the nonprofit should not send acknowledgments to donors indicating that the donations are deductible as charitable contributions.
While awaiting IRS approval, it is important that the nonprofit maintains compliance with filing requirements. If Form 990 (or Form 990-EZ or 990-N) is due while the organization is awaiting approval, the nonprofit should file the appropriate form by its due date (including extensions). In this case, the organization should check the “Application pending” box at the top of Form 990 or 990-EZ. Once the nonprofit is granted tax-exempt status, it is crucial to adhere to ongoing compliance requirements. This includes filing annual information returns (Form 990, 990-EZ, or 990-N) and keeping proper records of the organization’s activities and finances. Failure to file the proper information return for three consecutive years will lead to automatic revocation of tax-exempt status by the IRS.
Step Four – State Filings (where applicable)
In addition to federal tax-exempt status, the organization may be required to file in its respective state(s) for recognition of tax-exempt status by the state(s). Some accept receipt of federal status as proof of state tax-exempt status, while others require more forms/information to be submitted. States may also provide exemption from other taxes (e.g., sales tax on purchases, real estate, or personal property taxes). The organization should consult a tax adviser to determine which tax exemptions may be available to the nonprofit.
Once state tax-exempt status is received, it is important to follow federal and state filing and other requirements to maintain tax-exempt status.
Final Thoughts
When pursuing tax-exempt status as a nonprofit organization, it is prudent to consult with both an attorney and a CPA who specialize in working with tax-exempt organizations. As explained above, these professionals can help a new nonprofit pursuing tax-exempt status explore options and plan to maintain compliance and maximize tax exemptions. With advance planning, nonprofit leaders can focus on their important mission knowing that the tax-exempt organization’s operations are set up optimally to maximize the resources that reach its beneficiaries.
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