Tax Rules for Nonprofit Organizations: How Tax-Exemption Works

Are Nonprofits Taxed?

A nonprofit organization operates for charitable, educational, religious, or similar purposes rather than for private profit, according to the IRS. Most nonprofits qualify for federal tax exemption under Section 501(c) of the Internal Revenue Code (IRC) if they meet strict requirements on the purpose, governance, and use of funds. To maintain tax-free status, nonprofits must comply with reporting and operational rules, and they may owe taxes on income from unrelated business activities. State tax exemptions vary, making compliance with both federal and state regulations essential.

Understanding Nonprofit Tax Exemption

In addition to not paying federal taxes (provided that the nonprofit has obtained a determination letter from the IRS recognizing tax exemption), nonprofits may be exempt from paying state sales tax, income tax, and property tax. These benefits vary from state to state and depend on whether the taxable transactions relate to a nonprofit's charitable mission. For example, some states require nonprofits to pay sales tax on consumption, while others differentiate based on the type of nonprofit and whether it sells goods or services for income. Additionally, a nonprofit's tax-free status does not relieve it from ensuring employee's payroll taxes (Social Security and Medicare) are submitted.

Organizations must meet several requirements to achieve tax-free status. Some of the key criteria that nonprofits must meet to be tax-exempt include:

• Be organized and operated exclusively for charitable, scientific, religious, or public safety purposes
• Collect income and turn over the entire amount (minus expenses) to organizations or individuals who are lawfully recognized as legitimate charities
• Written articles of organization, legally registered and incorporated within the state it operates in

Nonprofits, which can include private foundations and churches, are able to more readily raise money as a non-taxable organization.

To be considered for tax-free status, an organization must be organized for and operate for one of the following purposes under tax laws:

• Religious
• Charitable
• Scientific
• Public safety testing
• Literary
• Educational
• National or international sports competitions
• Preventing cruelty to children and animal
• Corporations who hold and collect income from property to turn over to an exempt organization
• Certain civic leagues or organizations
• Labor, agricultural, or horticultural organizations
• Certain business leagues, boards of trade, real estate boards, and not-for-profit professional football leagues
• Recreation and pleasure activity clubs
• Voluntary employees' beneficiary associations
• Certain fraternal benefits orders
• Certain local teachers' retirement fund associations
• Specific local life insurance associations
• Other organizations, associations, trusts, or other structures operating without profit

The tax-free status is not automatically awarded to every organization. Once approved as a tax-exempt organization, an annual exemption form must be filed. However, some do not need to file annually, such as churches, private religious schools, certain trusts or pension plans, or an exclusively religious activity (this is not an all-inclusive list).

Many other forms might need to be submitted, so it's best to use the services of an accountant or tax professional familiar with nonprofit tax laws.

Important Tax Considerations for Nonprofits

If a nonprofit organization engages in activities unrelated to its primary purpose, it must pay income taxes on that money. For example, if the nonprofit organization ABC Shelters was formed to provide shelter for people experiencing homelessness, but it makes some money selling reconditioned bicycles, it might be required to pay taxes on that income.

Tax-free status benefits these organizations, but nonprofits generally have less flexibility because they are subjected to greater oversight by authorities and regulators.

The Bottom Line

Tax-exempt status lets qualifying nonprofits operate without paying federal income taxes in recognition of the public benefits they provide. To obtain and maintain this status, organizations must apply for IRS approval and remain in ongoing compliance by showing that their activities meet exempt-purpose requirements. Any non-qualifying or unrelated business activities can have immediate consequences, including taxation on that income, and in more serious cases, may jeopardize an organization’s tax-exempt status.