Qualifying and Keeping Your Tax-Exempt Status

Tax Professionals' Resource
April 18, 2014 — 2,131 views  
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Non-profit and tax-exempt status aren't the same thing, though they are connected to each other. Most non-profit organizations are also tax-exempt entities or wish to be. The processes of becoming a non-profit organization and receiving tax-exempt status are different.

The first and most important difference is that the state grants non-profit status, while the federal government, through the IRS (Internal Revenue Service) grants tax-exempt status. The connection between the two is that to apply for tax-exempt status the entity needs to be a non-profit.

Qualifications for tax exempt status

As mentioned above, to receive the tax-exempt status the entity needs to be a non-profit. So, first let’s look at what constitutes a non-profit organization.

Three types of non-profit organizations:

Corporation – It is best suited for community organizations. The structure of the organization must be as per state laws, with a board of directors in place, and rules of operation. And it provides protection against personal liability.

Unincorporated organization – The structure is quite similar to a corporation, but instead of articles of incorporation there is a constitution or policies.

Trust – The scope of interest is narrower. It is mostly suitable for charitable organizations.

Once, the state grants non-profit status, the procedure to acquire tax-exempt status starts.

Types of tax-exemption

There are 29 types of tax-exemptions as per section 501(c) of IRS. Describing and discussing all 29 types does fall under the scope of this article. You can read about them here. We will focus on the most common type – 501(c)(3) – that provides exemption from federal income tax to non-profit organizations that are charitable, religious, scientific, work towards prevention of crimes against children, work in the educational field, etc.

Exemption requirements under 501(c)(3)

  • The organization’s scope of operation must be limited to the purposes mentioned in the section. Learn about these purposes here.
  • None of the organization’s earnings should benefit any individual or shareholder.
  • The organization cannot be involved in political and lobbying activities.

Maintaining tax-exempt status

For a charitable organization or most other non-profit organizations it is extremely important to maintain their tax-exempt status. Losing the status could be equal to shutting down.

  • The organizational structure must be transparent. The board of directors should be entrusted with the job of forming policies, and the other officers of the organizations should be entrusted with the day-to-day operation.
  • Thorough documentation of corporate records is a must. The records should include minutes of all meetings and documents pertaining to all corporate decisions. This not only aids in maintaining the tax-exempt status, but also helps preserve the directors’ personal liability.
  • Contributing money for political campaigns or partaking in lobbying is prohibited.
  • Distribution of profits, to any member of the organization, is strictly prohibited.
  • Income generated from any ‘unrelated activities’ is liable to income tax, and has to be paid.


Tax Professionals' Resource