Section 501(C)(3) is an Internal Revenue Code (IRC) for nonprofit organizations that have been approved for tax-exempt purposes. Organizations under section 501(c)(3) of the IRC are commonly known as charitable organizations.
Breaking Down 501(c)(3) Organizations
The United States Internal Revenue Code (IRC) incorporated subsection 501c into its tax laws to evaluate whether a nonprofit organization should be exempt from federal income tax. The 501c is most popular for its benefits, which offers tax deductions to donors who contribute to nonprofit organizations. There are 29 forms of 501c organizations, but the most common form is the 501(c)(3) which is reserved for charitable foundations.
Tax Exemption Purposes
A 501(c)(3) is a charitable organization that is involved in religious, charitable, educational, literary, preventing cruelty to animals and children, fostering amateur sports competition (locally and internationally), testing for public safety, and scientific activities or operations. This list expresses the purpose for which a 501(c)(3) organization may be approved for tax exemption. In other words, these are the exemption purposes for the existence of a charitable foundation. The most popular forms of charitable associations are churches, schools, nursing homes, and humanitarian programs such as Red Cross and Salvation Army. Following these examples, the existence of a charity program must be to advance religion; provide relief for the poor, sick, and underprivileged; promote education and science; lower the government’s burden; defend human rights; combat juvenile delinquency; etc.
Requirements for 501(c)(3) Exempt Status
To be exempt for tax purposes under the Internal Revenue Service (IRS) guidelines, a 501(c)(3) organization must operate exclusively for the exemption purposes mentioned above. Any profits made by the organization must be used solely for the advancement of its charitable cause, and not for the benefit of any private shareholder or individual. Employees working for a 501(c)(3) are only to be paid the fair market value that the job function requires, with no expectation of bonuses or compensation. Also, a charitable organization is mandated to withhold federal income tax from its employees’ paychecks even though the organization itself is exempt from making income tax payments. Exceptions to the withholding rule apply if the employee earns less than $100 in a calendar year or if the organization is a religious institution opposed to paying Social Security and Medicare taxes.
A charitable organization must stay true to its purpose for existence. An organization who reported to the IRS that its mission is to send the less privileged in the country to college must maintain this purpose. If it decides to engage in another calling—say sending relief to displaced families in poverty-stricken countries—the 501(c)(3) organization has to first notify the IRS of its change of operations so that it does not lose its tax-exempt status.
Maintaining 501(c)(3) Status
To remain tax-exempt, a 501(c)(3) organization may not be substantially involved in any campaign activity that supports or opposes any political candidate. A charitable organization is not permitted to engage in lobbying except the expenditures are below a certain amount, depending on the size of the organization. Excise taxes may be applied to lobbying expenditures that are above a certain threshold.
While some unrelated business income is allowed for a 501(c)(3) foundation, the tax-exempt charity may not receive substantial income from unrelated business operations. This means that the majority of the firm’s efforts must go towards its exempt purpose as a non-profit organization. Any unrelated business from sales of merchandise or rental properties must be limited.
Charitable Tax Deductions
501(c)(3) organizations can be classified into two categories—Public Charities and Private Foundations. A Public Charity is a nonprofit organization that receives a substantial portion of its income or revenue from the general public or the government. At least one-third of its income must be received from the donations of the general public (including individuals, corporations, and other nonprofit organizations) to remain a public charity by IRS standards.
For tax purposes, an individual who makes charitable contributions may qualify for certain tax deductions that the IRS provides for donors. These tax deductions can help individuals lower their taxable income. For example, an individual who earns $60,000 and donates $10,000 to his or her church in tithes and offerings, may be eligible to deduct $10,000 from his income. His effective tax rate would therefore be applied to $60,000 – $10,000 = $50,000, instead of $60,000 taxable income. Generally, donations to a section 501(c)(3) organization can be tax-deductible for an individual for up to 50% of his or her adjusted gross income (AGI). In the example given above, if the individual donates $35,000, he will only be able to deduct his taxable income by $30,000.
A private foundation receives funds from a few public sources, and many of them do not accept donations. Income may come from a very small pool of donors, and it is not uncommon for a private foundation to have only one donor. All 501(c)(3) organizations are automatically classified as private foundations unless they meet the IRS standards for what is considered a public charity. A family foundation is an example of a private foundation. Donations to a private foundation are eligible for tax deductions up to 30% of the donor’s adjusted gross income.
Applying for Tax-Exemption
To apply for federal tax-exempt status under section 501(c)(3), a nonprofit organization must file Form 1023 or 1023-EZ within 27 months from the date of incorporation. The charitable organization must include its article of incorporation and provide documents that prove that the organization is only operating for exempt purposes.
Not all 501(c)(3) organizations need to submit Form 1023. Churches and public charities with less than $5,000 revenue per year are exempt from filing the form, but may still choose to do so to ensure that contributions made to them will be tax-deductible.