For most entrepreneurs, taxes are a regular part of running a business. However, certain types of organizations can qualify as tax-exempt, meaning they are not subject to federal income taxes. 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)s 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 organization — grants tax exemption 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 too, including the responsibility of maintaining compliance with nonprofit regulations. Nonprofits have less flexibility, and they must keep thorough records and regularly report to the IRS or face losing their status.
Additionally, even if you qualify for tax-exempt status, you’ll still be required to pay state and local taxes. Once you've qualified for a federal tax exemption, you can apply for an exemption from your state government as well.
[Read more: How Do Charitable Donations Impact Your Taxes?]
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)s 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 their annual returns. You’ll also need to pay estimated taxes if their unrelated business income is expected to exceed $500 for the year.
[Read more: A Complete Guide to Filing Your Business Taxes]
If you operate a charity, receiving tax-exempt status gives you legitimacy.
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.
Jamie Johnson also contributed to this article.
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