Nonprofit Organizations, and Taxes
Nonprofit Organizations, and Taxes
In recognition of the "public good"-oriented goals and objectives of nonprofit organizations, U.S. law grants these groups a number of special privileges. Of these, perhaps none is more valuable than the bestowal of tax-exempt status. Such status basically means that the organization's income and assets are not subject to federal taxes, and federal exemptions often (though not always) pave the way for state and local tax exemptions as well. For-profit enterprises, on the other hand, are subject to local, state, and federal taxation.
One of the main objectives of private enterprise is the pursuit of profit for the owners of the enterprise. Profits gained through private enterprise are taxable. Activities undertaken by tax-exempt organizations have as their objective obtaining profits for use in the continued provision of services for the public good. Profits earned by organizations as a result of their tax-exempt missions are not taxable. Nonprofit organizations can engage in virtually any business enterprise in the fulfillment of their mission objectives without jeopardizing their tax-exempt status. When these organizations undertake activities that are unrelated to their stated missions, than the profits generated from those activities are taxable. It should be noted, however, that complete exemption from federal taxation does not automatically mean that the organization avoids other kinds of taxation, such as state and/or local income taxes, sales taxes, and property taxes.
Bruce R. Hopkins noted in his Legal Guide to Starting and Managing a Nonprofit Organization that not all nonprofit organizations qualify as tax-exempt organizations: "Nearly every tax-exempt organization is a non-profit organization, but not all nonprofit organizations are eligible to be tax-exempt," he said. "The concept of a nonprofit organization is broader than that of a tax-exempt organization. Some types of non-profit organizations (such as mutual, self-help type entities) do not, as a matter of federal law, qualify for tax-exempt status." While the majority of nonprofit organizations are presumed to be tax-exempt in nature, there are exceptions to that premise. The terms nonprofit and charitable are not interchangeable. A nonprofit organization is not necessarily charitably motivated while an organization that is truly charitable in nature may well be a profit-making enterprise. Both types of organizations may be entitled to tax-exempt status from the IRS. For example, a religious and apostolic association, even if it is organized for profit, and a teacher's retirement fund association, which is operated to produce profits for its beneficiaries, are both eligible for tax exemptions.
DEVELOPMENT OF NONPROFIT TAX-EXEMPT STATUS
Until the end of the 19th century, all U.S. entities—whether they were private individuals or businesses—were exempt from taxation unless they were subject to a particular tax levy. The Tariff Act of 1894, however, changed that situation irrevocably. That legislation imposed a flat 2 percent tax rate on all U.S. corporations, but in recognition of the fundamentally different goals and objectives of for-profit businesses and charitable and educational groups, the bill exempted the latter organizations from the tax. The important aspect of this legislation is that organizations involved in activities and those whose profits would be used for altruistic purposes were specifically excluded from the requirement to share the profits of their work through taxation. The initial emphasis of tax exemption was to protect those organizations involved in charitable activities from taxation, and it has remained as the central function of tax-exempt law to this day.
In recent years, the United States has seen a dramatic increase in the number of tax-exempt organizations operating around the country. Indeed, the rise in the number of churches, nursing homes, hospitals, chambers of commerce, charitable organizations, and social service agencies in many communities has led some observers to voice concern about the tax-base stability of some areas. Some cities and towns find that a substantial portion of their entire lot of privately held real estate is owned by tax-exempt organizations. In such areas there may not be any revenue flowing into local tax coffers from a taxable base. This state of affairs has led some corporate and individual taxpayers to register complaints about the "free ride" that some exempt organizations enjoy. Even the tax-exempt status of churches, protected from the very beginning of the tax code, has been questioned in recent years.
NONPROFITS AND PROFITABILITY
Many people operate under a fundamental misconception about nonprofit organizations and revenue. The word 'nonprofit' may carry with it an inference about profit that causes some people to think profitability by a nonprofit organization is illegal. This is not at all the case. Nonprofit, tax-exempt organizations are free to do anything a for-profit company might do in pursuit of their goals, including making profits. The law is designed to provide all the benefits of a free-market system plus the special favor of tax incentives for individuals and corporations who want to contribute financially to our efforts. Not only may nonprofit organizations operate enterprises profitably as tax-exempt organizations, they may also prosper through the patronage of others.
But there are significant stipulations in place concerning the distribution of those profits that must be met for an organization to claim tax-exempt status. These are delineated in Section 501 of the Internal Revenue Code:
- The organization must be organized and operated exclusively for one or more of the following purposes: for religious, educational, charitable, scientific, or literary purposes; to test for public safety; to encourage amateur sports competition (either national or international); to prevent cruelty to children or animals; to lessen the burdens of government (through creation and/or maintenance of public buildings, monuments, parks, natural attractions, etc.); and to maintain public confidence in the legal system. Naturally, the organization may be involved in more than one of the above areas.
- Net earnings garnered by the organization may not, under any circumstances, be distributed for the private benefit of individuals.
- The organization may not participate in any way in any political campaigns, directly or indirectly (although it can use a political action committee or PAC to engage in political activities that are not political campaign activities).
- The organization may not spend "excessive" time or energy on efforts to influence legislation. It is a common misconception that nonprofits may not engage in legislative activities, but as Hopkins stated, "a charity is permitted to engage in far more lobbying efforts than most people realize. Indeed, under some circumstances, a charitable organization can spend more than one-fifth of its funds for legislative ends."
FILING FOR TAX-EXEMPT STATUS
A wide variety of organizations are eligible for tax-exempt status because of their goals and activities. These include the following:
- Corporations organized under an Act of Congress (includes federal credit unions)
- Title-holding corporations for exempt organizations
- Religious organizations
- Educational organizations
- Charitable organizations
- Scientific organizations
- Literary organizations
- Public safety organizations
- Organizations devoted to national or international amateur sports competitions
- Organizations devoted to preventing cruelty to children
- Organizations devoted to preventing cruelty to animals
- Civic leagues
- Social welfare organizations
- Local associations
- Labor organizations
- Agricultural and horticultural organizations
- Business leagues, chambers of commerce, and real estate boards
- Social and recreational clubs
- Fraternal beneficiary societies and associations
- Voluntary employees' beneficiary associations
- Domestic fraternal societies and associations
- Teachers' retirement fund associations
- Benevolent life insurance associations
- Mutual irrigation or ditch companies
- Mutual or cooperative telephone companies
- Cemetery companies
- State-chartered credit unions and mutual reserve funds
- Mutual insurance companies or associations
- Cooperative agricultural organizations
- Supplemental unemployment benefit trusts
- Employee funded pension trusts (provided they were created prior to June 25, 1959)
- Organizations of past or present Armed Forces members
- Group legal services organizations
- Black lung benefit trusts
- Withdrawal liability payment funds
- Veteran's organizations (provided they were created prior to 1880)
- Religious and apostolic associations
- Cooperative hospital service organizations
- Cooperating service groups of operating educational organizations
- Farmer's cooperatives
- Political organizations (parties, committees, etc.)
- Homeowners' associations
Some organizations such as churches, associations of churches, and auxiliary agencies of churches—like mission societies and youth groups—are generally considered automatically tax-exempt. They are not required to request this status from the government taxing agencies. Virtually all other kinds of organizations that fit legal definitions of eligibility for tax-exempt status because of their special benevolent purposes and goals cannot make the same assumption. They must ask the Internal Revenue Service to officially recognize their tax-exempt status."
To do so, organizations have to file an application for tax exemption with the IRS (nonprofit organizations may also have to make separate applications to state and local tax agencies if they wish to secure exemptions from taxes imposed by those jurisdictions). In most instances, this filing step is a mere formality; approval of tax exemption is almost always based on the IRS's ruling on the organization's exemption application (the primary legal basis for all tax exemptions is Section 501 of the Internal Revenue Code of 1954). Organizations that have their exemption application approved, then, will often find that they are free from tax obligations at the local and state levels as well.
Experts note that while some nonprofit organizations are exempted from paying certain taxes, that does not mean that they have no filing obligations. "Despite the favoritism the law frequently bestows on nonprofit organizations, the reporting requirements are not one of them, particularly when the organization is tax-exempt," said Hopkins. "The annual information return that most tax-exempt organizations have to file with the IRS is far more extensive than the tax returns most commercial businesses must file. Then, there may be several state annual reports (if the organization is doing business in more than one state) and the state annual charitable solicitation act reports (perhaps over 40 of them)." Given this reality, most nonprofit organizations choose to use the services of professional attorneys and accountants in compiling and delivering these reports.
UNRELATED BUSINESS INCOME
United States law has long differentiated between the activities of tax-exempt organizations that are related to the performance of tax-exempt functions and those that are not. Income garnered from these latter activities is subject to taxation. For incorporated organizations, net revenue from unrelated activities is subject to federal corporate income tax law, while for organizations that are not incorporated, this revenue—commonly referred to as "unrelated business income"—is subject to the canon of federal tax law on individuals. "The objective of the unrelated business income tax is to prevent unfair competition between tax-exempt organizations and for-profit, commercial enterprises," explained Hopkins. "The rules are intended to place the unrelated business activities of an exempt organization on the same tax basis as those of a nonexempt business with which it competes…. An organization's tax exemption will be denied or revoked if an inappropriate portion of its activities is not promoting one or more of its exempt purposes."
This area of tax law, noted Hopkins, has been one marked by upheaval and change in recent years. "As tax-exempt organizations struggle to generate additional income in these days of declining governmental support, proposed adverse tax reform, more sophisticated management, and greater pressure for more services, [tax-exempt organizations] are increasingly drawn to service-provider activities, some of which may be unrelated to their exempt purposes. The growth of service-provider activities, the increasing tendencies of the courts to find activities unrelated because they are 'commercial,' and the unrest over 'unfair competition' between tax-exempt organizations and for-profit entities—all of these are clear evidence that this aspect of the law of tax-exempt organizations is constantly evolving and will be reshaped." One emerging issue involves use of the Internet by nonprofit organizations. Some experts have expressed concern that linking to non-exempt sites, soliciting contributions online, or disseminating protected information could put an entity's exempt status at risk.
Anderson, Alice M., and Robert A. Wexler. "Making Use of the Internet—Issues for Tax-Exempt Organizations." Journal of Taxation. May 2000.
Baldas, Tresa. "Profiting at Nonprofits? The IRS gets tough on charities after reports of high pay for some nonprofit executives." Corporate Counsel. December 2004.
Hopkins, Bruce R. The Law of Tax-Exempt Organizations. Eighth Edition. John Wiley & Sons, April 2003
Hopkins, Bruce R. A Legal Guide to Starting and Managing a Nonprofit Organization. Second Edition. John Wiley & Sons, 1993.
Jacobs, Jerald A., and Karen L. Cipriani. "Establishing an Affiliated Organization." Association Management. June 2000.
Pakroo, Peri. Starting and Building a Nonprofit. Nolo, April 2005.
Schlesinger, Sanford J. "Unrelated Business Income and the Charitable Organization." Estate Planning. May 2000.
Wright, Carolyn D. "IRS Request for Comments on EO Web Activity: Good Start." Tax Notes. 23 October 2000.
Hillstrom, Northern Lights
updated by Magee, ECDI
"Nonprofit Organizations, and Taxes." Encyclopedia of Small Business. 2007. Encyclopedia.com. (July 30, 2016). http://www.encyclopedia.com/doc/1G2-2687200411.html
"Nonprofit Organizations, and Taxes." Encyclopedia of Small Business. 2007. Retrieved July 30, 2016 from Encyclopedia.com: http://www.encyclopedia.com/doc/1G2-2687200411.html