For most entrepreneurs, taxes are a regular part of running a business. However, certain types of organizations can qualify for tax-exempt status, meaning they are not subject to federal income tax. Securing this status involves meeting and maintaining certain qualifications.
Below, we’ll break down what it means to be tax-exempt and how you can apply.
What is a tax-exempt organization?
A tax-exempt organization is a business entity that does not have to pay federal income taxes. Nonprofits, which reinvest earnings to support their mission, are eligible to receive tax-exempt status.
However, tax exemption isn’t automatically granted to 501(c)(3) organizations and related nonprofits. Tax exemption and nonprofit status, while similar, require two separate processes to earn those benefits. The state grants nonprofit status, while the IRS—a federal agency—grants tax-exempt status.
Achieving tax-exempt status offers many benefits, including:
- Saving money: Tax-exempt organizations can save money by not paying federal taxes, as well as sales tax in certain places.
- Charitable donations: If you operate a charity, receiving tax-exempt status gives you legitimacy. That's because, as a tax-exempt organization, your donors can write off their charitable donations on their tax returns.
- Greater opportunity for funding: According to Karla Dennis, an Enrolled Tax Agent and CEO and Founder of KDA, Inc., tax-exempt status opens up access to grants, government funding, and tax-deductible donor giving.
- Enhanced credibility: “When you’re recognized as tax-exempt, it boosts your reputation, making you more appealing to donors and grant-making foundations,” Dennis explained.
However, tax exemption comes with some drawbacks, including the responsibility for maintaining compliance with nonprofit regulations. Nonprofits have less flexibility and must keep thorough records and regularly report to the IRS, or risk losing their status.
Additionally, even if you qualify for tax-exempt status, you’ll still be required to pay state and local taxes. However, once you've qualified for a federal tax exemption, you can apply for an exemption from your state government as well.
[Read more: 11 Things to Consider When Starting a Nonprofit]
What businesses are tax-exempt?
According to the Tax Policy Center, certain types of organizations are eligible for tax-exempt status. The following types of organizations would qualify:
- Churches and religious organizations.
- Art museums and historical societies.
- Nonprofit credit unions and labor unions.
- Nonprofit hospitals.
- Humane societies.
- Public society groups.
- Social welfare groups.
- Human services, like the Girl Scouts, the YMCA, or food banks.
- Veterans' organizations.
- Scientific research organizations.
[Read more: Nonprofit vs. Not-for-Profit vs. For-Profit: What's the Difference?]
Tax obligations for exempt organizations
Despite not paying income taxes, exempt organizations are still responsible for certain tax obligations, including:
- Employment tax: Tax-exempt businesses with employees must withhold Federal Income Tax Withholding (FITW) from employee wages and contribute to Social Security and Medicare taxes (FICA). Non-501(c)(3) organizations may also be required to pay the Federal Unemployment Tax (FUTA). State or local taxes may also apply.
- Annual returns: Tax-exempt organizations—except churches and church-affiliated organizations—must file annual returns with the IRS. Organizations with gross receipts totaling below a certain amount (currently $50,000) can file an annual electronic notice (Form 990-N) instead.
- Taxes on unrelated activities: Income from activities unrelated to the organization’s mission must be reported on a business income tax return. If the unrelated income totals $1,000 or more, you must file a Form 990-T separate from your annual returns. You’ll also need to pay estimated taxes if your unrelated business income is expected to exceed $500 for the year.
[Read more: A Complete Guide to Filing Your Business Taxes]
Many people conflate nonprofit and tax-exempt status. Nonprofit status is a state law concept. Tax exemptions are set forth by the IRS.
How to apply for tax-exempt status
The process of applying for tax-exempt status is not easy and can take a long time to complete. If you're ready to get started, here are the steps you'll take:
- Incorporate your business: First, establish a legal business entity and apply through your state’s Secretary of State. Decide on a business name, establish a board of directors, file necessary paperwork including Articles of Incorporation, and choose a registered agent.
- Obtain your EIN: All organizations need an employee identification number (EIN) for tax and banking purposes. As a nonprofit, you’ll also need to submit documents like financial statements, copies of any amendments to your organizing documents, and a list of key personnel’s salaries.
- Figure out your tax-exempt status: Once you have all the necessary company paperwork, you need to determine what type of tax-exempt status you're applying for. You’ll also need to ensure your business has a clear, charitable mission that aligns with IRS requirements, Dennis advised. Check with your state and local tax authorities about your tax-exempt status, as requirements vary and your organization may not automatically qualify for exemptions at these levels.
- Submit your application: Make sure to fill out the forms correctly because minor errors can delay the application process. If the purpose of your organization changes during the application process, you're required to let the IRS know in writing.
Consulting a tax professional can help you navigate and ensure compliance throughout the application process, Dennis said.
When will I find out if my application is approved?
The IRS should contact you within 180 days of submitting your application. However, if it seems to be taking a long time, you can check its status. The IRS will thoroughly review your application, so if you make any mistakes, this can slow down the process considerably.
The IRS approves most tax-exempt applications, but there is always the possibility your application could be denied. If this happens, it's a good idea to consult with your CPA and find out why the application was turned down. It could be something as simple as applying to be classified as a different type of nonprofit organization.
How to maintain your tax-exempt status
Once you’ve earned your tax-exempt status, you’ll need to meet certain requirements to uphold it:
- Designate a board: Nonprofit organizations must establish a board of directors who oversee the organization and make decisions with the organization's best interests in mind.
- Stick to your mission: Deviating from your original purpose, conducting activities for private interest, or distributing assets to benefit internal parties can all cause an organization to lose its status.
- Steer clear of political activity: Tax-exempt organizations cannot participate in any form of political campaigning and should avoid lobbying.
- Avoid unrelated income: Generating revenue is allowed for tax-exempt organizations, but it must be connected to your organization’s purpose.
- Report annually to the IRS: Tax-exempt organizations must complete a Form 990 return annually or face potential status forfeiture.
- Keep detailed donation records: Every donation received must be documented, and you should provide a receipt so the donor can claim it as a tax deduction at the end of the year. “Having someone to maintain your books and records will be very important,” emphasized Dennis.
To learn more about maintaining compliance, the IRS offers a variety of online training courses to help your organization stay exempt.
Common reasons the IRS revokes tax-exempt status
The only entity that can revoke an organization’s tax-exempt status is the IRS, and the process is quite specific. In most cases, an audit takes place before status is revoked, with an appeals process and other opportunities for the tax-exempt entity to make their case.
The IRS will audit a tax-exempt organization for a few common reasons. Form 990 is usually the first trigger. “When Form 990 is submitted with incomplete or inaccurate information, it gives the appearance of a non-compliant organization,” wrote Carr, Riggs & Ingram, a law firm. “The IRS also uses Form 990 to identify governance issues that they feel can lead to non-compliance.”
Make sure you fill out Form 990 carefully, and consult with a tax expert if you’re not sure what information to include.
The second trigger for an IRS audit is a direct referral. Individuals, watchdog groups, and government agencies can report on potential issues that could violate tax exemption compliance. One common referral is from state tax agencies when an organization failed to file in the state, has a payroll issue, or appears to be noncompliant in other ways. Know the rules of your state when it comes to filing taxes.
Finally, Carr, Riggs, & Ingram note that the IRS is scrutinizing organizations with large foreign grants. “Previously, areas of non-compliance concerning control of overseas expenditures, reporting of foreign bank accounts, and inadequate record keeping have been found,” wrote the law firm. If you accept money via international grants, meticulous bookkeeping is vital.
State-level tax exemptions: how they differ from federal rules
Many people conflate nonprofit and tax-exempt status. Nonprofit status is a state law concept. Tax exemptions are set forth by the IRS. Incorporating a nonprofit with the state merely establishes it as a legal business entity; exemption from taxes is a further step layered on top of that.
With that distinction, tax exemption at the state level varies. “Many states do not have a separate tax-exempt application. Some states have a one- or two-page form that must be completed while others have a more detailed application process,” wrote Wolters Kluwer.
Certain states allow state-level tax-exempt status, and in such cases the net profit is also exempt from state income taxes. The Council of Nonprofits has a list of state filing requirements, and you should work with a local tax expert to understand whether you’re able to apply for state tax exemption based on your location.
Jamie Johnson and Miranda Fraraccio also contributed to this article.
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