The government recognizes that charitable and certain other types of organizations provide valuable community services that would be impossible for the government to provide using taxpayer funds. While the government can’t fully support nonprofit organizations, the 501(c)(3) code of the IRS classifies them as tax-exempt. Not having to pay taxes on donations and on the funds they raise stretches their dollars, making it easier for them to continue providing valuable services for the community.
There are specific rules and regulations for starting a 501(c)(3), and there are rules for maintaining one. Failure to abide by those rules means losing tax-exempt status. The federal government also lists rules for dissolving charitable organizations. It’s important for organizations that qualify as tax-exempt to know and follow all applicable rules to avoid penalties and other liabilities.
Types of 501(c)(3) Organizations
The federal tax code lists several different types of organizations that don’t have to pay income taxes. Here are some of the basic categories:
- Religious organizations
- Educational institutions
- Scientific organizations
- Literary groups
- Groups that test for public safety
- Groups that foster national or international amateur sports competitions
- Anti-cruelty organizations for animals and children
The federal government also classifies private foundations as nonprofit organizations. These types of organizations are largely philanthropic in nature. Because they invest some percentage of their fundraising dollars, the federal government has different rules that they must abide by to maintain their status as a nonprofit organization. Organizations that receive more than one-third of their support from gross investment income are considered private foundations. The IRS requires private foundations to submit detailed tax returns.
Start-up Rules for 501(c)(3) Organizations
A 501(c)(3) organization typically begins when a group of people share a common goal of starting a nonprofit organization to fill a need within their community. After carefully choosing a name for the organization, the founders get to work writing the articles of incorporation.
The articles of incorporation must include the corporation’s name, contact information, purpose, registered agent, founding directors and information about shares of stock, because once they are filed, they become public record. In most states, founders file the form for the articles of incorporation with the Secretary of State’s office. Organizations usually have to designate an “incorporator” who signs and files the articles of incorporation with the proper authorities and pays the appropriate filing fee. There may be separate forms for applying for federal or state tax-exempt status.
Bylaws are separate and different from the articles of incorporation. The founding directors write the bylaws, which outline how the nonprofit runs, including the rights and responsibilities of officers and directors. Nonprofit organizations don’t have to file bylaws with the state, but they need to keep them in their files.
The next step is usually to appoint a founding board of directors and to hold the first board meeting. After that, the board needs to follow up on obtaining all of the proper licenses and permits, and to open a bank account for the nonprofit’s funds.
Requirements to Maintain 501(c)(3) Status
The government intends for nonprofit entities to remain nonprofit entities, so they set up some rules that tax-exempt organizations must obey in order to keep their tax-exempt status. Not knowing the rules isn’t an excuse for disobeying them. Those who try to blur or cross the line could end up with fines or face other legal consequences.
Here are six things to watch out for:
- Private benefit. Organizations that apply for tax-exempt status cannot serve the private interests, or private benefit, of any individual or organization besides itself past an insubstantial degree. Therefore, a nonprofit may not permit any of its income or assets to benefit insiders, such as board members, officers, directors and important employees.
- Nonprofits are not allowed to urge their members to support or oppose legislation. They may participate in a small amount of lobbying, but lobbying activities may not exceed a certain amount of the organization’s total expenses.
- Political campaign activity. A nonprofit organization may not financially support or endorse any political candidates verbally or in writing. They may not oppose candidates either. This rule applies to candidates at every level — local, state and federal.
- Unrelated business income. Nonprofit organizations aren’t allowed to generate too much income from a purpose that is unrelated to the nonprofit. An organization that regularly operates a trade or business that is unrelated to the nonprofit and makes significant contributions to the organization would need to pay taxes.
- Annual reporting obligation. Nonprofit corporations still have reporting responsibilities, like the Form 990. They may also be responsible for things like tax on unrelated income, employment tax, excise taxes, and certain state or local taxes. Churches and other church-related organizations don’t need to report income.
- Operate in accord with stated nonprofit purposes. An organization that makes a big shift from being unprofitable to making money needs to re-file as a for-profit entity and to pay the applicable taxes.
Dissolving a Nonprofit Organization
It’s much easier to start a nonprofit than it is to dissolve it, and nonprofits must obey certain rules in dissolving their organizations. The intent is to dissuade people from starting nonprofit organizations, shutting them down after a time and keeping the profits for themselves. There are certain steps related to dissolving a nonprofit, and it’s best to gain the help of an attorney or tax professional.
A nonprofit may only distribute assets to another tax-exempt organization. The board may vote to dissolve the organization, file dissolution papers with the state and the IRS, and select another nonprofit organization to which to transfer any assets.
The board will need to pay all contractual obligations and debts before dissolving the nonprofit. If there aren’t enough assets to pay remaining debts, the nonprofit may need to file bankruptcy. The board could be held liable for not properly dissolving a tax-exempt organization.
It’s important to remember that the government values nonprofit organizations for their commitment and sacrifice. The nonprofit savings in tax dollars are intended to serve the public in their communities, not to profit individuals or groups of individuals. The rules and regulations are designed with the intent that nonprofits will start out strong and enjoy long-term sustainability. Nonprofits that decide to close their doors for whatever reason don’t get to pocket any remaining funds.