In simple terms, a 501(c)(3) nonprofit is a group that exists for charitable purposes. The IRS establishes the different types of 501(c)(3) organizations and determines the rules and laws for operating them depending on their classifications.
As straightforward as that sounds, nonprofit boards must be aware of the rules and restrictions that govern nonprofits to continue operating legally.
We’re providing an overview of 501(c)(3) organizations including the following topics:
- 501(c)(3) definition
- Types of 501(c)(3) organizations
- The value of a board management system in setting up a 501(c)(3) organization
- Requirements, restrictions and tax rules for a 501(c)(3)s
Defining Nonprofits: What Is a 501(c)(3)?
So, exactly what is a 501(c)(3) organization? The federal government describes the types of nonprofits exempt from federal income tax in the 501(c)(3) section of the United States Internal Revenue Code. The 501 code refers to organizations that were founded for the following purposes:
- Prevention of cruelty to animals
- Prevention of cruelty to children
Nonprofits must receive at least of third of their income from donations given by the general public, and they may also receive income from the government.
While 501(c)(3) organizations benefit from donations, individuals who make donations also benefit from donating to nonprofits in the way of tax donations. That’s a great incentive for people and businesses to lower their taxable income while supporting their favorite charities.
Typically, individuals can make donations for up to half of their adjusted gross income and still get the tax break. It’s a win-win situation for nonprofits and those who donate to them.
Societies also benefit from 501(c)(3) organizations as they get the benefit of a social return due to the programs and services nonprofits provide.
There Are Three Main Types of 501(c)(3)s
The IRS designates three main types of 501(c)(3) organizations that may be allowed to operate under the 501(c)(3) form.
Organizations that qualify for 501(c)(3) status must operate exclusively for the purpose they state to the IRS. All 501(c)(3) organizations must have a board of directors that governs the organization.
We’ll describe each of the different types of 501(c)(3) organizations below:
1. Charitable Organizations
Public charities are the most common type of 501(c)(3) nonprofits. These nonprofits receive a significant portion of their funds from the government or the general public. A public charity must receive at least a third of its income from donations.
Donations typically come from individuals, corporations, private foundations, and other nonprofit organizations.
A few examples of public charities include:
- Medical research organizations
- Food banks
- Relief organizations
- Organizations to prevent cruelty to animals
- Environmental organizations
- Human rights organizations
2. Churches and Other Religious Organizations
Churches, religious schools, and other religious organizations are eligible for 501(c)(3) status. This includes all denominations and religious affiliations including churches, synagogues, mosques, and temples.
Churches and religious organizations do not need to get formal recognition when they submit a 501(c)(3) application, and they don’t have to submit annual tax returns. Even though church groups are not required to formalize their 501(c)(3) status, they must adhere to all the same requirements as other nonprofit organizations.
3. Private Foundations
Private foundations are sometimes called non-operating foundations. An individual, a family, or a small group of donors usually funds the foundation with their own money. Family foundations are a common type of private foundation. Donors for private foundations may donate up to 30% of their income without paying taxes on it.
This type of 501(c)(3) doesn’t have any active programs. Private foundations grant money to other nonprofit organizations or to individuals who are working on the same tax-exempt purpose.
What Are the Requirements for Section 501(c)(3)?
The IRS approves charitable organizations according to their purpose. For example, charitable organizations must exist for one of the reasons listed above.
The IRS is also specific about what they consider to be charitable activities. These activities include:
- Providing relief for the poor, distressed and underprivileged
- Advancing religion
- Advancing science or education
- Erecting or maintaining public buildings, monuments or works
- Lessening the burden of governments
- Lessening neighborhood tensions
- Eliminating prejudice and discrimination
- Defending human and civil rights secured by law
- Combatting community deterioration
- Addressing juvenile delinquency
The basic rules for these types of organizations prevent nonprofits from serving private interests, including the interests of the founder, founder’s family, shareholders or other people that have controlling interests in the organization. Nonprofits are required to use all donations for the sole purpose of advancing the stated charitable cause.
Restrictions for 501(c)(3) Organizations
The restrictions for 501(c)(3) organizations are designed so nonprofits will focus their efforts on charitable causes.
Nonprofits must abide by the following restrictions:
- Nonprofits may not serve the interests of the founder, the founder’s family, shareholders, or other people that have controlling interests in the organization.
- Nonprofits must use all donations for the sole purpose of advancing the stated charitable cause.
- Nonprofits may not engage in political advocacy or lobbying as a primary activity.
- Nonprofits may not donate directly to any political candidate’s campaign fund.
- Nonprofits may not campaign actively for any political candidates.
As it pertains to political activities, nonprofit organizations may support specific legislation or advocate for their cause, as long as it’s not a major part of the nonprofit’s programs and activities.
Rules for Tax Exemptions for 501(c)(3) Organizations
Nonprofits that don’t follow the rules for 501(c)(3) status may receive fines, penalties, and loss of tax-exempt status. Nonprofit boards need to know that not everything is tax-exempt.
These points make for great board education and discussion:
- Nonprofits aren’t allowed to receive a substantial amount of income from unrelated business operations (UBI-unrelated business income).
- Some types of UBI are allowable, but the majority of income must support the 501(c)(3)’s stated purpose.
- Nonprofits are allowed to sell merchandise or rental properties on a limited basis.
- Nonprofit organizations must withhold federal income taxes from employees’ paychecks for employees that make over $100 per calendar year.
- Nonprofits must file IRS Form 1023 or Form 1023 EZ in the first 27 months of their date of incorporation unless they earn less than $5,000 per year (nonprofits may choose to file it so that donors get the tax advantages).
- Nonprofits are required to file Form 990 every year.
Examples of 501(c)(3) Organizations
- Scripps Research – A private, nonprofit biomedical research organization that is known for work in infectious diseases, molecular and cellular biology, immunology, and synthetic vaccine development. Scripps qualifies for 501(c)(3) status under the description of scientific nonprofits.
- The Loft: A Minnesota nonprofit that promotes the development of writers, literary awareness, and a passion for literature. They offer grants and awards for writers, and it qualifies as a nonprofit under the literary definition.
- John F. Finn Institute for Public Safety: A nonprofit that is dedicated to things like police accountability, controlling gangs, preventing juvenile delinquency and more. The organization qualifies as a nonprofit under the IRS rule for testing for public safety.
- Special Olympics: An organization that promotes athletic ability and sports competitions for individuals with intellectual disabilities. This nonprofit qualifies for tax-exempt status under the category of fostering national or international amateur sports competitions.
Advantages and Disadvantages of Starting a 501(c)(3) Organization
When starting a 501(c)(3) organization, founders have a vision in mind for something they want to see changed or improved. While that is laudable and there are many advantages to starting a nonprofit, founders are wise to consider some of the disadvantages of starting a 501(c)(3).
|Advantages of a 501(c)(3)||Disadvantages of a 501(c)(3)|
|Board, Staff, and volunteers are invested in the cause||Can be challenging to fundraise|
|Qualifies for federal tax-exempt status||Limits on political lobbying|
|Helps communities thrive||May be scrutinized by donors and community members|
|Eligible for grants and major gifts||Takes time, effort, and funding to be sustainable|
|Protection from personal liability||Subject to government oversight, must remain in compliance|
Taking the Next Step: Setting Up Your Own 501(c)(3)
501(c)(3) organizations must be founded for one of the specific purposes as outlined by the IRS. Understanding what constitutes a tax-exempt nonprofit and its requirements and restrictions is the first step toward turning your idea of establishing your own organization a reality.
Now it’s time to explore more about the next steps in the process. Our article How to Create a 501(c)(3) Organization details a nine-point process to found a new tax-exempt nonprofit.