TAX EXEMPTION STATUS

The major benefit of charitable nonprofit organizations is that they may qualify for exemption from Federal and State income tax.  In addition, corporate donors may deduct contributions to organizations that are exempt under section 501(c)(3) of the Internal Revenue Code from their personal Federal income tax.  A tax professional must be retained by the nonprofit because of the complexities involved. The process for obtaining tax-exempt status is separate from the incorporation process.   

FEDERAL INCOME TAX EXEMPTION

Section 501(c)(3) of the Internal Revenue Code, which is codified in Title 26 of the United States Code, states that the following are exempt from taxation: 

Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.”

Essentially the advantage of obtaining charitable Internal Revenue Code (IRC) Section 501(c)(3) tax-exempt status are:

  1. Exemption from Federal and State income tax on earned and investment income, except for net income from unrelated business purposes, or investment income from assets acquired with debt;   
  2. Charitable contributions from individuals are tax-deductible; 
  3. Many grants from Government, foundations, and corporations are limited to 501(c)(3) organizations; and 
  4. Tax-exempt organizations qualify to purchase property through bargain sales, in which the property may be bought at a less than fair market value, and the seller will receive a tax deduction for the difference between the value and the sales price.           

To qualify for exemption from Federal income tax, a nonprofit organization must satisfy both the organizational test and the operational test.

ORGANIZATIONAL TEST

According to the Internal Revenue Code, a section 501(c)(3) organization must be “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes.” The organizational test is satisfied if the Articles of Incorporation includes language that limits the purpose of the organization to the exempt purposes listed in section 501(c)(3) of the Internal Revenue Code.  The Articles of Incorporation must state that the organization cannot engage in any substantial activities which does not further the exempt purposes. Moreover, the organization must expressly dedicate its assets to exempt purposes in the event of dissolution.  

OPERATIONAL TEST

The nonprofit must also satisfy the operational test, which requires the organization to engage primarily in activities to accomplish an exempt purpose specified in section 501(c)(3) of the Internal Revenue Code.  The organization must not divert charitable assets to private individuals, pay excessive compensation to officers and directors, or engage in prohibited political activities. The organization must not participate in politics by supporting or opposing a particular candidate for public office.  The organization must not engage in substantial lobbying. Moreover, to obtain tax exemption in California, more than half of the board of directors must be disinterested – meaning that not more than 49% of the directors can receive compensation or be related to a person receiving compensation from the organization.  

PUBLIC CHARITIES AND PRIVATE FOUNDATIONS

A 501(c)(3) organization must be classified as either a Private Foundation or a Public Charity based on the level of public involvement in its activities. 

PUBLIC CHARITY

A Public Charity receives the majority of its financial support from the general public or Government entities.  In doing so, Public Charities interact greatly with the public. An organization will be classified as a Public Charity if it receives a certain percentage of its total financial or program support from Government sources, other Public Charities, or a broad base of individual donors.  The calculation required to obtain Public Charity status from public donations is complex. Tax professionals will need to be consulted and an IRS Form 8940 must be submitted. If the organization is classified as a Public Charity due to receiving financial support from the public, the IRS classification status will be valid for five (5) years.  In advance of the end of the five (5) year period, the organization will be required to submit IRS Form 8734. In addition, an organization can be classified as a Public Charity, and avoid the more rigorous classification as a Private Foundation, if it satisfies the IRS definition of a church, school, hospital, or museum.  

Most active 501(c)(3) organizations are Public Charities because they have higher donor tax-deductible contribution limits and can attract support from other Public Charities and Private Foundations.  Also, Public Charities have three possible tax filing requirements that range in complexity and depend on annual revenue: (1) Form 990 must be filed for Public Charities with annual revenue greater than $200,000.00; (2) Form 990-EZ must be filed for Public Charities with annual revenue between $50,000.00 and $200,000.00; or (3) Form 990-N E-Postcard can be filed for Public Charities with annual revenue less than $50,000.00.  Whereas, Private Foundations must file the rigorous Form 990-PF each year regardless of revenue (it is comparable to the more complex Form 990 for Public Charities). 

PRIVATE FOUNDATION

A Private Foundation is many times controlled by members of a single family, by a small group, or by a corporation retaining control over operations and grants.  As a result, much of the Private Foundation’s financial support is from specific sources and investments. Private Foundations are not subjected to strict public scrutiny.  However, Private Foundations are instead subjected to various operating requirements and restrictions. For instance, classification as a Private Foundation has disadvantages in that a two percent (2%) excise tax is imposed on the organization’s net investment income, there are limits on the deductions of charitable contributions by individual donors, and there are more burdensome financial reporting requirements.   

PRESUMPTION OF PRIVATE FOUNDATION 

Pursuant to tax laws, a section 501(c)(3) organization is presumed to be a Private Foundation.  The organization must request and qualify as a Public Charity and receive a ruling or determination by submitting IRS Form 8940.

IRS FORM 1023 

To apply for Federal tax exemption, IRS Form 1023 must be filed within twenty-seven (27) months of incorporation with the Internal Revenue Service.  Form 1023 must be signed by a principal officer, an authorized employee, the Attorney for the nonprofit, or an agent with Power of Attorney to act on behalf of the nonprofit.  Included with the Form 1023 must be:

  • Certified copy of the Articles of Incorporation from the Secretary of State;
  • Copy of the Bylaws signed by a principal officer or certified by a declaration from an authorized officer stating that the Bylaws are the true and complete copy;
  • Statement of receipts and disbursements;
  • Current balance sheet;
  • Proposed budget for two (2) years; and
  • Executed copy of a consent to extend the period in which to assess tax (Form 872-C), unless the organization is a Private Foundation which does not need to submit Form 872-C.

The fee for Form 1023 is based on the projected gross receipts of the nonprofit.  The fee is $400.00 if the nonprofit has an annual gross receipts of less than $10,000.00 in the preceding four (4) years of existence or if the projection for a newly formed nonprofit is less than $10,000.00.  The fee is $850.00 if annual gross receipts are more than $10,000.00. It takes at least three (3) months after filing Form 1023 to receive an approval from the IRS.   

CALIFORNIA STATE INCOME TAX EXEMPTION

In California, corporations are subjected to an annual franchise tax on net income.  However, nonprofit corporations can apply to be exempt from this annual franchise tax.  

To obtain exemption from State income tax, FTB Form 3500 must be filed with the California Franchise Tax Board with a $25.00 Fee.  If the corporation has already received a letter from the IRS recognizing its 501(c)(3) exemption status, the corporation may file Form 3500A for no fee and attach the IRS letter.    

PROPERTY AND SALES TAX

Even though a charity is exempt from income tax, the organization is still responsible for applicable property tax and sales tax.  Local and State property and sales tax statements and returns must be filed.  

However, in California the corporation may apply for a property tax exemption known as the Welfare Property Tax Exemption for its taxable real or personal property.      

In California there is no exemption from sales tax for charities.  If the nonprofit is selling merchandise, a Sellers Permit and Resale Certificate from the California State Board of Equalization must be obtained. 

The State Board of Equalization and local county tax assessor can be consulted to clarify what taxes are still required by the organization.    

LOCAL BUSINESS LICENSE

The nonprofit may be subjected to local business license permits and local business taxes.  The local City Clerk should be consulted to determine if any other taxes are applicable to the nonprofit.  Charitable corporations are often exempt from payment of local business license taxes.  

LOS ANGELES BUSINESS LAWYER TO GET TAX EXEMPTION STATUS

If you need to form a nonprofit organization, contact a business attorney at The Sterling Firm. We have an attorney experienced in forming nonprofits. We can help! Call now to speak with an attorney!