A 501(c)(3) nonprofit corporation is a type of charitable organization that the Internal Revenue Service (IRS) recognizes as tax-exempt. A nonprofit corporation does not pay income tax on its earnings or the donations it receives.
- The five steps to becoming a 501(c)(3) corporation are: choose a purpose, form a corporation, file paperwork with the IRS, comply with state and local requirements, and maintain your nonprofit status.
- Becoming a nonprofit means you are exempt from certain tax requirements that apply to other types of businesses.
- Because of the complicated tax situation, a 501(c)(3) corporation must spend a good chunk of its time making sure it stays current with the IRS.
Benefits of a 501(c)(3)
Whenever taxpayers make a donation to a 501(c)(3) nonprofit, they can reduce their taxable income by the amount of their donation if they itemize their deductions on their federal income tax return. This incentive encourages private charity and makes it easier for nonprofits to raise money.
For tax year 2021 only, married couples filing jointly who don’t itemize but rather take the standard deduction can still deduct $600 worth of their charitable donations ($300 for single filers).
If you’ve ever wanted to raise money for a cause on your own terms, you might want to start a 501(c)(3). Here is what you should consider before you decide and how to get started if you choose to move forward.
1. Choose a Purpose
Federal tax law states that if you want to operate as a 501(c)(3), your organization must exclusively pursue one of the following purposes:
- Literary or educational
- Testing for public safety
- Fostering national or international amateur sports competitions
- Preventing cruelty to children or animals
You should also be sure that your organization is not designed to profit an individual and that it provides a public benefit.
2. Form a Corporation
When you’ve determined that your organization roughly meets the IRS requirements and you want to proceed, it’s time to start dealing with the red tape. A lawyer can provide personalized guidance and help you avoid costly mistakes, but some people do manage on their own.
Corporations are formed at the state level, so you’ll need to find out what the procedure is to form one in the state where your organization will be based. The steps vary by state but will generally include the following:
- Name the corporation, making sure that your name is unique and permissible. In other words, you can’t use a name that someone else has already claimed. Also, there are certain words the government doesn’t allow corporations to use in their names in an effort to prevent businesses from misleading the public.
- Prepare and file articles of incorporation, which are the documents that create your corporation.
- Appoint one to three directors, depending on your needs and state requirements. All corporations must have directors whose responsibility is to oversee the organization, advise management, and make key decisions such as hiring and firing the company’s executive officers. They do not oversee daily business activities; the officers do that.
- Hold a directors meeting in which you appoint/elect officers and prepare to organize documents and bylaws. Also, start a record book in which you keep minutes from this and subsequent meetings.
- Get a state tax identification number. A corporation is considered an independent taxpaying entity and must have its own tax number (the equivalent of an individual’s Social Security number), even if it is not going to pay taxes.
In addition to following the official, required steps, it’s not a bad idea to make a business plan, just like you would if you were starting a for-profit business. Although your organization will be a nonprofit, you will still have to operate in the black if you want to keep it running.
Nonprofits are allowed to make money; they just have to use those profits to further the organization’s public purpose. By contrast, a private corporation exists to enrich its employees, managers, and shareholders.
3. File Paperwork With the IRS
After meeting your state’s requirements for forming a corporation, you’re ready to apply for tax-exempt status with the IRS.
First, you’ll now need to apply for a federal employer identification number (EIN). This is a requirement for all tax-exempt organizations, even if they don’t have employees. You can apply online through the IRS website, by phone, or by mailing or faxing in Form SS-4, Application for Employer Identification Number.
Next, complete and submit Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. This can only be done online. The information that you include on this form will serve as the basis of whether the IRS decides to grant your organization tax-exempt status. Set aside plenty of time for this task; the main application is 11 pages long and quite detailed. And depending on the type of organization you are forming, you will also need to fill out one of the attached schedules (e.g., Schedule A for churches; Schedule B for schools, colleges, and universities; etc.)
IRS Form 1023 helps ensure that you’ve included all required information in your application and will help to prevent delays in processing.
Submit your application. The IRS will let you know if it needs more information or if your form has been forwarded for review. When the IRS has all of the information it requires, it will issue a determination letter either granting or denying tax-exempt status to your organization. The evaluation process usually takes three to five months. If you are denied, you can appeal.
4. Comply With State and Local Requirements
If your organization gets approved for tax-exempt status at the federal level, that’s great. Next, you’ll need to make sure it will also be tax-exempt at the state and local levels, so it doesn’t have to pay state corporate income tax, sales tax, or property tax. Requirements vary by state, but your IRS approval may be all your organization needs to also be recognized as a nonprofit at the state level.
When you’ve met your state’s requirements for operating as a nonprofit, you’ll need to get any permits or licenses required to operate your business and make sure to comply with building codes and other local regulations.
Before you start operating, familiarize yourself with corporate requirements, such as holding meetings, keeping minutes, and filing information returns.
5. Maintain Your Nonprofit Status
When you’ve been approved at every level, there’s still work to do. Maintaining your nonprofit status is an ongoing process, and the consequences are severe if you don’t abide by the rules. Here is a list of self-imposed guidelines you need to follow on a regular basis:
- Make sure your organization operates the way you said it would in your application.
- Hold regular meetings of the board of directors and take notes.
- Comply with annual IRS requirements to file Form 990 or Form 990-EZ. In these forms, you will report your organization’s activities, governance, revenue, expenses, and net assets.
- Have diverse funding sources because 501(c)(3) organizations are supposed to be public. If you have too few funding sources, you might have to reorganize as a private foundation. Foundations operate by a completely different set of rules.
- Run your organization like a business with its own bank account and credit card. Keep all financial transactions completely separate from your personal accounts.
- Keep impeccable financial records in case your organization is audited.
- Do not allow your organization to participate in any political campaigns.
- Do not unjustly enrich anyone compensated by your organization.
- Do not use your organization to further nonexempt purposes or to commit illegal acts.
- Do not allow a substantial part of your organization’s activities to be geared toward influencing legislation.
- Avoid earning unrelated business income through your organization. This is income from an activity that is regularly carried on and is not substantially related to your organization’s purpose. Such income is subject to the unrelated business income tax.
If you have a sizable number of employees, consider starting a qualified retirement plan. These plans resemble 401(k) plans in many respects but are specially designed for nonprofit entities.
What Does 501(c)(3) Mean?
Subsection 501(c) is a subsection of the Internal Revenue Code (IRC)—or what's often referred to as the tax code. It covers nonprofit organizations and tax law; specifically, it lists 12 types of organizations that are exempt from paying federal income tax. The third—501(c)(3)—includes "corporations, funds, or foundations that operate for religious, charitable, scientific, literary, or educational purposes." This is the sort of nonprofit most people are likely to have contact with—the American Red Cross and Direct Relief are two common examples—and to which they donate money.
What Are the Application Fees to Set Up a 501(c)(3)?
Filing your nonprofit's articles of incorporation with your state typically costs about $100. The IRS Form 1023 filing fee is $600. However, for organizations that expect less than $50,000 in annual earnings, Form 1023-EZ can be filed for $275. But remember: You may also want to budget for legal help. A lawyer can provide guidance for your particular nonprofit and help you avoid costly mistakes.
How Long Does the 501(c)(3) Application Process Take?
After you submit a completed Form 1023, the IRS will let you know if it needs more information. Depending on how thoroughly you've prepared the application, the evaluation process can take three to five months or more. When the IRS has all of the information it requires, it will issue a determination letter either granting or denying tax-exempt status to your organization. (You can appeal.) Form 1023-EZ applications take less time to process.
The Bottom Line
Starting a 501(c)(3) can be an exhausting process. Before you tackle the challenge, weigh the pros and cons of meeting all the legal and tax requirements when you form and operate an official nonprofit organization. It may well be worth it; people may donate more than they otherwise would because of the tax exemption and perceived increase in legitimacy 501(c)(3) status conveys.