A 501(c)(3) organization is a nonprofit established to fulfill a stated mission. Many 501(c)(3)s operate as charities, but the designation includes churches and private foundations. Given their philanthropic nature, all 501(c)(3)s are exempt from federal income and unemployment taxes.
What Is a 501(c)(3) Organization?
501(c)(3) is a reference to the section of the U.S. Internal Revenue Code outlining the requirements for an organization to be granted federal tax-exempt status. At a high level, this includes the following:
- It must be organized and operated as one of the following types of organizations: charitable organization, church/religious organization or private foundation.
- None of its net earnings may result in a benefit to any private shareholder or individual. All earnings must be used to help the organization fulfil its mission.
- It may not be an action organization, which means it may not attempt to influence legislation or participate in any political campaigns as a substantial part of its activities.
501(c)(3) organizations are often referred to as nonprofits, but these terms are different. A nonprofit is an entity that is organized for a nonprofit purpose. A 501(c)(3) organization is a nonprofit that has been recognized by the Internal Revenue Service as being tax-exempt.
The Internal Revenue Service (IRS) defines charitable activities fairly broadly, making specific reference to efforts designed to bring relief to the poor, the distressed, or the underprivileged; advance religion; advance education or science; erect or maintain public buildings, monuments, or works; lessen the burdens of government; lessen neighborhood tensions; eliminate prejudice and discrimination; defend human and civil rights secured by law; and combat community deterioration and juvenile delinquency.
Across this diverse spectrum of activities, the IRS states that “organizations organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, educational, or other specified purposes and that meet certain other requirements are tax exempt under Internal Revenue Code Section 501(c)(3).”
Some of the best known 501(c)(3) charities are United Way Worldwide, Goodwill Industries International, St. Jude Children’s Research Hospital, the Salvation Army and the YMCA of the USA.
Churches and Religious Organizations
The IRS does not specifically define the terms church or religious organization. However, it does attribute the following characteristics to churches:
- Distinct legal existence
- Recognized creed and form of worship
- Definite and distinct ecclesiastical government, with a formal code of doctrine and discipline
- Distinct religious history
- Membership not associated with any other church or denomination
- Organization of ordained ministers, who are selected after completing prescribed courses of study
- Literature of its own
- Established places of worship, with regular congregations and religious services
- Sunday schools for the religious instruction of the young and other schools for the preparation of its members
These characteristics, along with other considerations, factor into the determination as to whether an organization qualifies for 501(c)(3) status as a church or religious organization.
Most of the time, private foundations are nonprofits that support one or more charitable organizations via grants. They exist to conduct charitable activities, but in an indirect way.
Typically, they have one major source of funding, such as gifts from a wealthy family or corporation. Every 501(c)(3) organization is automatically classified as a private foundation, unless it satisfies the requirements necessary to achieve classification as a charitable organization or a church/religious organization.
This distinction is important, because private foundations are subject to stricter rules and regulations than public charities.
Advantages of a 501(c)(3) Organization
501(c)(3) organizations serve philanthropic purposes that are believed to benefit society. In support of their missions, the U.S. government grants these organizations exemption from federal income tax and unemployment tax.
While state-specific laws vary, most states also exempt qualified 501(c)(3) organizations from income tax. Many also provide exemptions on sales and property taxes. Similar accommodations are made at the local level.
In addition to the tax advantages, 501(c)(3) organizations are eligible to receive government and private grants that are not available to profit-seeking enterprises. Many also receive preferential pricing and VIP service offerings from vendors.
The tax breaks extend beyond the actual 501(c)(3) organizations. Generally, donations made to these IRS-qualified organizations are tax-deductible for itemizing taxpayers, up to certain limits. This valuable allowance encourages charitable gifting and enhances the fundraising potential of 501(c)(3)s.
How Do You Set One Up?
To create a 501(c)(3) organization, the first step is to clearly define its mission. Then, you need to determine the type of nonprofit you wish to establish.
From here, you need to select a name for the organization and establish an appropriate governance structure. This means forming a board of directors and writing the nonprofit’s bylaws.
After completing the steps above, you must file articles of incorporation with the state in which the nonprofit is going to be organized. Then, you can file for 501(c)(3) tax-exempt status with the federal government.
Generally, this entails filing Form 1023 or Form 1023-EZ within 27 months of incorporation. The filing must include the articles of incorporation and supplemental documentation outlining the organization’s structure, governance and programs.
Keep in mind: Not all nonprofits seeking 501(c)(3) status are required to submit Form 1023 or Form 1023-EZ. Public charities that generate less than $5,000 in revenue per year are exempted. Nevertheless, many small nonprofits still file the form to ensure their donors receive favorable tax treatment.
Ongoing Compliance Requirements
All 501(c)(3) organizations must operate with full transparency, which means their finances, including details on the salaries they pay, are made available to the public.
With regard to compensation, pay must be based on the fair market value associated with job functions, exclusive of bonuses and supplemental compensation. Bonuses and supplement compensation are permitted, but they must not be excessive.
To maintain 501(c)(3) status, an organization must not deviate from its mission. No change in purpose is permitted. If an organization desires to change its mission, it must notify the IRS and address pertinent regulatory requirements.
Beyond these governing principles, maintaining 501(c)(3) status involves satisfying compliance requirements at both the federal and state level.
A key annual requirement is the filing of an annual report known as IRS Form 990. This form is the primary tool for gathering information about tax-exempt organizations, educating organizations about tax law requirements and promoting compliance.
Most states also rely on Form 990 to perform regulatory oversight functions, including the review/validation of state income tax exemptions.
In addition to Form 990, many states require charitable organizations to provide information regarding donor solicitations.
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- Internal Revenue Service. (2021, September 23). Exempt Organization Types. Retrieved from https://www.irs.gov/charities-non-profits/exempt-organization-types
- Internal Revenue Service. (2021, September 23). Churches Defined. Retrieved from https://www.irs.gov/charities-non-profits/churches-religious-organizations/churches-defined
- Internal Revenue Service. (2021, September 7). Exemption Requirements – 501(c)(3) Organizations. Retrieved from https://www.irs.gov/charities-non-profits/charitable-organizations/exemption-requirements-501c3-organizations
- Internal Revenue Service. (2021, July 9). About Form 990. Retrieved from https://www.irs.gov/forms-pubs/about-form-990
- Internal Revenue Service. (n.d.). Concept of Charity. Retrieved from https://www.irs.gov/pub/irs-tege/eotopicb80.pdf