Taxation of Nonprofit Organizations & IRS Compliance

Nonprofit organizations exist to serve a civic or social purpose rather than generate profit. They pursue the public good and promote specific causes such as poverty reduction, education, and healthcare, relying on donations and grants for funding. If you’re looking to start a nonprofit organization, understanding the nuances of nonprofit taxes is key to ensuring that your organization operates within the legal framework while maintaining its tax-exempt status.

Nonprofit organizations are exempt from federal income taxes under subsection 501(c) of the Internal Revenue Service (IRS) tax code. Nonprofit tax status may also be exempt from state sales tax, income tax, and property taxes. However, if a nonprofit organization engages in business activities that are unrelated to its primary purpose, it must pay taxes on the income generated.

Victory Tax Lawyers handle everything tax. Whether you need to know more about taxation of nonprofit organizations or you’re faced with a tax issue, we’re eager to help. Our team of trained lawyers is not only knowledgeable about tax laws but has handled a myriad of tax-related matters successfully. Schedule a free tax attorney consultation with us and discover how our excellent tax relief services can provide solutions to your tax troubles.

This post examines the taxation of nonprofit organization work, highlighting the IRS requirements to qualify for tax-exempt status. It also covers the specific situations that may require a nonprofit to pay taxes, as well as how to apply for a 501(c) tax exemption.

What Is a Nonprofit Organization?

 

A nonprofit organization is an organization formed to pursue mission-oriented goals rather than generate profits. Nonprofits work to further a charitable or social cause, providing goods and services that the government cannot provide to citizens. Unlike for-profit businesses, nonprofits reinvest any surplus revenue into their mission rather than distributing it to owners or shareholders. Often, nonprofits have a board of directors that oversees the organization’s operations and ensures the organization stays aligned within the scope of its intended purpose or mission.

The difference between nonprofits and for-profit organizations primarily lies in their mission. Nonprofits prioritize public good and community benefits over financial gain. Often, they rely on grants, donations, and fundraising to generate revenue, while for-profit organizations sell goods and services for profit. 

The organizational structure of a nonprofit has various implications for its business activities, corporate governance, and taxes. In the United States, nonprofit organizations are legally delineated from firms in the for-profit sector as they qualify for tax-exempt status. In essence, they don’t have to pay income taxes, and in many cases, donations made to them are tax-deductible. Whereas for-profit businesses are legally obligated to pay taxes on their earnings. Examples of nonprofits include national charities and foundations, social clubs, religious organizations, and educational institutions.

For transparency and accountability, they’re often required to make their financial and operating information public. This allows donors to see how the organization manages their funds, and aligns with its purpose. Nonprofits further reinvest any surplus from the generated income at the end of their fiscal year into the organization’s mission. They also usually receive tax-exempt status, exempting them from income taxes, and donations may be tax-deductible, unlike the for-profits, which pay taxes on profits. 

The IRS recognizes various types of nonprofit organizations, each classified under different sections of the tax code. The most common designations include:

• 501(c)(3) – Charitable, religious, educational, scientific, and literary organizations, as well as private foundations. Donations made to these organizations are typically tax-deductible.
• 501(c)(4) – Social welfare organizations, civic leagues, and local employee associations. These groups can engage in advocacy and lobbying, but don’t always offer tax-deductible donations.
• 501(c)(5) – Labor unions and agricultural organizations.
• 501(c)(6) – Business leagues, chambers of commerce, and professional associations.
• 501(c)(7) – Social and recreational clubs, such as hobby or sports organizations.
• 501(c)(9) – Voluntary employee benefit associations that provide benefits like health insurance to members.

Knowing these classifications will help you determine your tax obligation, fundraising capacity, and compliance requirements.

What Are the IRS Rules for Nonprofit Organizations?

Nonprofit organizations enjoy tax-exempt status. But this is only one part of the equation. Nonprofits need to stay compliant, navigating the various regulations that are relevant to their operations. Failure to adhere to these rules may result in the nullification of the tax-exempt status or attract certain penalties to the nonprofit.

To begin with, to qualify for a tax-exempt status, a nonprofit must be structured and operate exclusively for exempt purposes as defined by section 501(c)(3) of the Internal Revenue Code. At the very basic level, this implies that they must be organized and operated exclusively as a charitable organization.

In addition to this, nonprofits must make sure no part of their earnings benefits private individuals or shareholders. They’re also restricted from fully engaging in political and legislative (lobbying) activities. Finally, nonprofits must use all the funds generated to further their mission and not distribute them as profit.

Nonprofits must adhere to several IRS-imposed compliance measures, including:

• Annual Reporting: To maintain their tax-exempt status, nonprofits must file IRS Form 990 (or its appropriate variant) each year. This document provides the public with information about a nonprofit’s finances, mission activities, and governance. Beyond compliance, filing Form 990 enhances transparency and demonstrates accountability in financial management and mission-related activities. Nonprofits that fail to file for three consecutive years may have their tax-exempt status automatically revoked.
• Accurate Recordkeeping: Besides filing Form 990, nonprofits must maintain proper records of all their financial transactions, donor contributions, and operational expenses. This practice is very necessary since they’re their books are usually audited. The audits often include reviewing their statements of financial position, statements of activities, and other state-specific requirements for financial reporting.

Nonprofits make their financial statements and governance documents accessible to the public in order to provide the IRS and donors proof of compliance on key financial and operational details. Nonprofits that fail to keep the IRS guidelines on compliance risk losing their tax-exempt status, accruing fines and penalties, and in severe cases, facing legal action if the breach was due to financial mismanagement or fraud.

Do Nonprofit Organizations Pay Taxes?

Being a nonprofit indeed makes you eligible for exemptions from state sales, property, and income taxes under subsection 501(c) of the Internal Revenue Service (IRS) tax code. The government offers this tax break to these organizations to help them stay afloat since they exist purely for the public good.

Nonetheless, simply being a nonprofit does not automatically absolve you from the need to pay your federal income tax. To qualify, nonprofits still have to apply to the Internal Revenue Service for recognition of exemption. This often involves getting a determination letter, which validates and confirms their tax-exempt status and lets them maximize federal tax savings.

Together with the above, nonprofits must meet other general requirements to enjoy federal tax-exempt status, including:

1. Be organized and operated exclusively for charitable purposes
2. Not turn over part of its net earnings to the benefit of any private individual or shareholder
3. Not participate in political activities or attempt to influence legislation as a major part of its activities.
4. Have written articles of organization, legally registered, and incorporated

Taxable Income For a Nonprofit

While nonprofits enjoy tax-exempt status for income related to their primary mission, they aren’t automatically exempt from all taxes. There are circumstances under which nonprofits may still need to pay taxes. For instance, if a nonprofit engages in activities unrelated to its primary purpose as stated in its articles, that income is subject to taxation. Such income is referred to as Unrelated Business Taxable Income (UBTI).

However, this rule applies to unrelated activities that are regularly recurring (weekly, monthly, or annually). One-time business activities are usually tax-exempt. This clause implies that nonprofits are allowed to engage in unrelated business activities as long as the revenue remains within reasonable limits. The key difference to note is that income directly tied to the organization’s mission remains tax-exempt, while profits from unrelated ventures may be taxable.

State and Local Tax Obligations for Nonprofit Corporations

As we already mentioned, nonprofits may be exempt from paying state sales,  property, and income taxes, but these benefits depend on whether the taxable transactions relate to a nonprofit’s charitable mission and vary from state to state.

For example, some states require nonprofits to pay sales tax on consumption, while others differentiate based on the type of nonprofit and whether it sells goods or services for income. Some states also consider the volume of the sales. In most cases, however, the sales tax for certain sales is waived for transactions relating to the charity’s “charitable mission.”

Sales Tax Exemptions: When Do Nonprofits Pay Sales Tax?

Many states grant sales tax exemptions to nonprofits, consequently allowing them to buy goods and services without paying sales tax. However, these exemptions are not universal. Some states require nonprofits to apply for sales tax exemption certificates.

Additionally, nonprofits that sell goods or services, such as selling merchandise, running fundraising events, or operating gift shops, may be required to collect and remit sales tax just like for-profit businesses. In many states, if a nonprofit vendor makes sales of taxable items or services, the nonprofit is obligated to collect and remit sales tax just like any other vendor.

It’s not a one-size-fits-all rule. The rules vary by state. So, nonprofits must confirm what is applicable in their state in order to determine whether they are responsible for collecting sales tax, so they don’t end up being penalized or, worse still, lose their tax-exempt status.

Property Tax Exemptions: Who Qualifies?

Every state exempts some or all of the properties owned by charitable nonprofits from property taxes. However, the property must meet the public, pious, or charitable use test. This means that the property must;

• Be dedicated unconditionally to public use;
• Be owned and operated on a not-for-profit basis; and 
• Directly benefit an indefinite class of persons who are part of the public, and must also confer a benefit on society as a result of the benefit conferred on the persons directly served.

Some states, however, argue that the fact that a nonprofit is recognized by the IRS as being described in Section 501(c)(3) doesn’t automatically exempt that organization from paying real property taxes. In states where property tax exemptions are approved for nonprofits, the question is often whether the institution or property use is “charitable.” Also, what qualifies as “charity?”

In Ohio, whether a property is exempt from taxation or not is generally dependent upon the use of the property. Real property tax exemptions in Ohio are often referred to as “use-based exemptions.” In other states like Pennsylvania, California, and Massachusetts, both ownership and use are important. California’s State Constitution provides for a “Welfare Exemption,” which exempts from real property taxes property that is used exclusively for religious, hospital, or charitable purposes and owned by corporations or entities that meet certain requirements. 

In Pennsylvania, certain property is considered exempt from real property taxes, including property owned by institutions of purely public charity and regularly used by such institutions. Similarly, in Massachusetts, property owned by charitable organizations and occupied and used for charitable purposes is exempt from real property taxes.

State-Level Registration and Reporting Obligations

Beyond tax compliance, many states require nonprofits to register with the attorney general’s office or a charitable solicitation agency if they plan to solicit donations. Additionally, nonprofits may need to file annual reports or renew their tax-exempt status with state agencies.

Failure to meet state and local tax obligations can result in fines, loss of tax-exempt status, and legal consequences. To ensure compliance, nonprofits should consult with tax professionals or legal experts familiar with their state’s regulations.

What Is Tax-Exempt Status? Nonprofit vs. 501(c)(3)

As we’ve tried to explain, a nonprofit organization isn’t structured to operate in such a way that it generates profit. This often implies that they don’t get to pay income taxes. But being eligible for exemptions doesn’t automatically mean they get to do nothing about it. To be recognized as a tax-exempt organization under federal law, they must apply for and receive tax-exempt status from the IRS.

Tax-exempt status refers to an exemption from federal income tax under the Internal Revenue Code. The IRS grants this status to nonprofits that qualify under sections 501(c)(3) through 501(c)(27), depending on their purpose and activities.

Although the IRS recognizes many other tax-exempt classifications, the most common tax-exempt designation is 501(c)(3), which applies to charitable, religious, and educational organizations. Other tax-exempt classifications include 501(c)(4): Social welfare organizations, 501(c)(5): Labor unions, 501(c)(6): Trade and professional associations, 501(c)(7): Social and recreational clubs, and 501(c)(9): Employee benefit associations.

Benefits of Tax-Exempt Status

While a nonprofit corporation is a state-level designation, the 501(c)(3) status is a federal designation awarded by the IRS. If an organization has 501(c)(3) status, it isn’t only exempt from federal income tax but may also not pay state income taxes (often varies by state). The organization, in addition, qualifies to receive tax-deductible donations, which is often a huge plus to donors.  Additional benefits of the tax-exempt status include:

• The public legitimacy of IRS recognition
• Ability to apply for grants and other public or private allocations available only to IRS-recognized, 501(c)(3) organizations
• Potentially higher thresholds before incurring federal and/or state unemployment tax liabilities
• Discounts on US Postal bulk-mail rates and other services

Most nonprofit organizations qualify for federal income tax exemption under Section 501(c) of the Internal Revenue Code. A few others do not, largely due to the stringent requirements for federal income tax exemption.

However, most tax-exempt organizations remain subject to a wide variety of other taxes, including federal payroll taxes. State and local unemployment taxes, personal property taxes, real estate taxes, franchise taxes, sales and use taxes, and taxes on lobbying activities may also apply. 

How a Nonprofit Can Qualify for Tax-Exempt Status

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. To apply for the tax-exempt status, follow these steps;

1. Determine if your Organization Qualifies for the Tax-Exempt Status

To qualify for tax-exempt status, an organization must;

• Operate and be organized for charitable purposes or public support.
• Conduct itself as either a limited liability company (LLC), a corporation, a trust, or an unincorporated association.
• Permanently dedicate their assets to exempt purposes and provide limitations to their purpose.

Nonprofit organizations are prohibited or restricted from participating in political campaigns and engaging in activities that violate fundamental public policy. They also must avoid advancing non-exempt purposes that favor private interests excessively or ignore the limits of its legislative activities. Performing these activities can cause them to lose their exemption status.

Research the applicable IRS provisions and determine the structure of your organization, whether a trust, corporation, or association.  A solid organizational structure and strong governance are crucial for your organization’s mission success. It clarifies roles, responsibilities, and reporting lines, ensuring smooth operations. It further fosters ensuring accountability and transparency, attracting funding.

2. Prepare and File the Necessary Documents

There are specific documents that the IRS will require during the application process. This includes your organization’s formation documents, Employer Identification Number (EIN), and IRS Form 8718 for your 501(c)(3) application. 

Your formation documents must specifically indicate whether the organization is religious, educational, charitable, scientific, literary, safety-oriented, or amateur sports-related. This lets the IRS ascertain that your organization is dedicated to charitable purposes. In addition, your document must show that the organization meets the 501(c)(3) requirements for the disposition of assets in the event the nonprofit is terminated.

Obtain your EIN online and fill out your Form 8718 application properly. If your organization is more than three years old, you’d be required to attach basic financial statements for the last three years. If you’re operating a new organization, you must provide a financial statement for the current year, along with projected budgets for the next two years. The statement must also include a detailed summary of your organization’s income sources and expenses. 

At this point, fill out the actual 501(c)(3) application and attach all other documents to it. Also, include a check or money order to cover the “Exempt Organization Determination” fee. You may find different versions of the 501(c)(3) application, also known as IRS Form 1023. Be sure to fill out the correct version for your organization. A tax professional can help you with that.

Once you’re done with filing your form and gathering the right supporting documents, submit electronically on the pay.gov website. 

3. Obtain Approval from the IRS

Once you file your organization’s tax-exempt status request with the IRS, you must wait for approval, which is validated by a determination letter confirming their recognition.

If your organization gets approval at the federal level, you’ll need to ensure your organization is also considered tax-exempt at the state and local levels. This prevents the organization from having to pay state corporate income tax, sales tax, or property tax. Requirements vary by state. 

Common Mistakes to Avoid When Applying

Here are some common mistakes nonprofits make when applying for Tax-Exempt Status:

1. Unclear Mission Statement: The application may be rejected if the nonprofit’s purpose is too vague or does not align with IRS-approved categories.
2. Incomplete Form 1023: Missing or incorrect information can lead to delays or even the denial of the application.
3. Lack of Governance Policies: Failing to have proper bylaws, a conflict-of-interest policy, or a board of directors may raise red flags.
4. Engaging in Private Benefit Transactions: If the nonprofit appears to benefit specific individuals rather than the public, it may not qualify.
5. Failing to Maintain Compliance: Once granted tax-exempt status, nonprofits must comply with IRS reporting rules, such as filing Form 990 annually.

Employment Taxes and Payroll Obligations

Even though nonprofits are typically considered tax-exempt, they are not exempt from payroll taxes if they have employees. Like for-profit businesses, nonprofits must adhere to the federal and state employment tax laws on proper withholding, reporting, and payment of payroll taxes.

Nonprofits are to withhold and pay employment taxes for their employees, including Federal Income Tax Withholding (FITW), Social Security and Medicare Taxes (FICA), Federal Unemployment Tax (FUTA), and State Payroll Taxes. While some nonprofits are exempt from FUTA, those that are not must pay unemployment taxes. Concerning State payroll taxes, some states may have additional unemployment insurance (SUTA), disability insurance (SDI), or local payroll tax requirements. You want to confirm what applies to your state so that you don’t err in compliance.

Nonprofits must also file payroll tax returns annually and/or quarterly. Some of the common filings include Form W2, Form 941, and possibly Form 1099-NEC, 1099-MISC. Form W-2 must show total wages and other compensation paid, total wages subject to social security and Medicare taxes, amounts deducted for income, social security and Medicare taxes, total advance EIC payment and allocated tips (if any).

In addition to payroll obligations, nonprofits must also comply with state fundraising and corporate registration requirements. The majority of states require nonprofits to register with the Division of Charities to qualify to solicit donations. Nonprofits fundraising in multiple states must also register in each of those states and renew that registration on an annual basis. In addition, nonprofits must file a corporate annual report for their state of incorporation, plus each state in which the nonprofit has a Certificate of Authority.

Finally, nonprofits must be careful to classify their workers correctly. Are they employees, independent contractors, or volunteers? The IRS distinguishes between employees, independent contractors, and volunteers, and each category comes with different payroll tax requirements. Properly classifying your workers will ensure you stay aligned to the payroll tax requirement that applies to them.

For instance, employees are subject to federal and state payroll taxes, including income tax withholding, Social Security (FICA), and unemployment taxes (FUTA). They also receive a W-2 form at the end of the year, whereas independent contractors are not subject to withholding tax; they’re instead issued Form 1099-NEC. Volunteers are typically not subject to payroll taxes of any kind since they are unpaid workers. However, nonprofits must ensure that volunteers are truly volunteers and not misclassified employees performing work that should be compensated.

How to Maintain Your Nonprofit’s Tax-Exempt Status

The key to maintaining your nonprofit’s tax-exempt status lies in adhering to tax rules and your nonprofit mission, as well as keeping up with other regular tasks. Below is a list of best practices that can help you maintain your nonprofit’s tax-exempt status;

1. Set up a corporate board to oversee the nonprofit’s activities and operations. The board of directors ensures the proper functioning of the organization, deliberates on important issues, and decides on the organization’s behalf.  Generally, the board acts in the organization’s best interests. 
2. Ensure the corporate board is knowledgeable. The board must be familiar with local, state, and federal nonprofit laws and its fiduciary duties. This ensures that decisions and policies align with relevant tax laws as well as the proper functioning of the organization. 
3. Regularly reviewing tax-exempt status and compliance obligations. In addition to ensuring your organization fits the legal definition of a tax-exempt, nonprofit organization, you want to regularly review your operations to ensure you’re always aligned with your mission/purpose, as stated in the article. If a nonprofit strays from its original purpose and scope, the IRS can nullify the tax exemption or reclassify the nonprofit as a private entity, making it liable to taxes. 
4. Filing annual information returns. The IRS requires most 501(c)(3) organizations to file an annual information return, declaring the organization’s activities, income, and expenses. Staying compliant with this rule keeps your organization in the IRS’s good book.
5. Limit political involvement and activities. According to IRS rules, nonprofits must avoid all political campaign activities. They must not participate in any activity or event that favors or endorses a particular candidate for political office. .
6. Document all donations received. If your nonprofit organization engages in fundraising activities and solicits donations from the public, you must provide a receipt to individuals who donate more than a specific dollar amount so that the individuals may apply for a year-end tax deduction.
7. Identify a source for legal consultations. Working closely with a tax professional is a surefire way to lessen the chances of running into tax errors or losing your tax-exempt status. A tax professional ensures you stay compliant with tax laws and, in the case of any problem with the IRS, can help you find a reliable solution.

Want Guidance from a Tax Lawyer You Can Trust?

To become a tax-exempt nonprofit, you must file for tax-exempt status, a process that can be quite complex, if we’re being honest.  The application form spans roughly 30 pages, and the IRS estimates it takes about eight hours to complete, assuming you’re well-versed in tax law and have maintained accurate records. The expert guidance of a tax professional is undoubtedly handy in this process. 

A tax professional understands the tedious regulatory landscape and can make the often difficult process seamless. Complying with nonprofit state filing requirements is another mission-critical area where the expertise and experience of a tax lawyer shine. 

If you’re looking for the best tax lawyer to handle your tax concerns, we excel in tax law, focusing on aspects like tax disputes, audits, and tax litigation. Our tax lawyers are dedicated to assisting both individuals and organizations in steering through the often complicated terrain of tax regulation and compliance. We’ve provided a free consultation to let you share your tax concerns without any cost.

Frequently Asked Questions

Do nonprofit employees pay taxes on their salaries?

While nonprofits themselves may be exempt from paying federal income taxes, their employees are still required to pay taxes on their wages. Employees of nonprofit organizations must pay federal and state income taxes, Social Security, and Medicare taxes. Nonprofits are also required to withhold and remit payroll taxes just like any other employer. In addition to these standard withholdings, nonprofits may be responsible for paying federal and state unemployment taxes, depending on the state in which they operate.

How can a tax attorney help a nonprofit?

A nonprofit can benefit from the guidance of a tax lawyer in a number of ways. They can help with the initial process of filing for your tax-exempt status, making sure you’re in compliance with IRS regulations and not making common mistakes. A tax attorney can also help nonprofits stay compliant with tax laws by advising on unrelated business income tax (UBIT) and structuring activities in a way that minimizes tax liability. In terms of representation, should you have IRS audits or legal disputes, a tax lawyer can stand in for you and assist you in resolving any compliance issues. Additionally, they can provide counsel on employment tax matters, state tax obligations, and governance structures to ensure that the organization operates within the legal framework required for maintaining tax-exempt status.

Do nonprofits pay taxes in California?

Nonprofits operating in California may qualify for exemption from state income tax, but they must apply separately for state-level tax-exempt status through the California Franchise Tax Board (FTB). Even if a nonprofit is recognized as tax-exempt by the IRS, it does not automatically receive state tax exemption. Nonprofits in California may still need to collect and remit sales tax if they sell goods or services, and property tax exemptions are only available to organizations that meet specific requirements. Additionally, nonprofits that solicit donations in California must register with the state’s Attorney General’s Office and comply with annual reporting obligations.