Federal income taxes are inevitable for most businesses. However, nonprofit organizations -- those that exist primarily to improve society and provide specific services to the public, can apply to the IRS for tax exempt status using the steps outlined in this post.
Once you establish your organization as tax exempt, you may need then the help of outsourced accounting services in order to meet regulatory reporting requirements.
What is Tax Exempt Status?
Tax exempt status is a legal state that allows a business to forego paying taxes on sales and purchases, as determined by the Federal government. Several categories exist for tax exempt businesses. In fact, IRS Publication 557 outlines 33 unique codes for exempt organizations.
However, in today’s landscape we are most often engaging with those who register under tax code 501(c)(3). These include major categories of business eligible for tax exempt status as follows:
- Charitable, Religious and Educational Organizations
- Other 501(c)(3) Nonprofits
Federal and state governments work together during the tax exemption process. And state governments determine which business are charitable, religious, educational or if they fall into the category of other 501(c)(3)s. The Federal government then reviews and accepts applications for tax exempt status from qualifying organizations.
Determine if Your Business Should Be Tax Exempt
Charitable, religious and educational organizations are universally recognized and don’t have to pay federal taxes on things they purchase and sell. These organizations include:
- Churches, temples and other religious organizations
- Some veterans organizations
- Fraternities and Sororities
- Social welfare organizations
- Schools and other educational organizations
Other 501(c)(3) nonprofits include entities such as:
- Organizations specific to agriculture and horticulture
- Scientific organizations that work toward advances for the greater good and make their research findings public
- Member associations
- Some HOAs organized to benefit the community
All 501(c)(3)s are required to renew their status with the federal government each year.
Note: Other organizations can operate under some tax exemptions, per code 501(a) of IRS Publication 557. These are niche organizations like title companies, credit unions, cemetery companies and companies organized under an act of Congress. They do not represent the vast majority of businesses seeking this status. For more information on how to claim tax exempt status under 501(a), visit the IRS website.
A 501(c)(3) organization is one that files for exemption through Section 501(c)(3) of the federal tax code. It is a distinct designation that some nonprofits may apply for that includes a number of additional tax benefits such as:
- Eligibility to deduct charitable gifts
- Employment tax exemption (FUTA)
- Exemption from some state and local taxes
There are a few general qualifications a business must meet to be eligible for a 501(c)(3) exemption:
- The organization must operate for a charitable purpose. This could be religious, scientific, educational or other as described above.
- Stakeholders (e.g. the organization’s founder) should not receive any portion of Net Income. To calculate Net Income, use this equation: [Total Revenue - Cost of Doing Business (including line items such as depreciation) = Net Income (NI)].
- The organization cannot be politically motivated or affiliated.
- The business must operate legally and in the public interest and should not be in violation of public policy.
If your business meets these requirements, it could be eligible for tax exempt status.
Converting Your LLC to 501(c)(3)
But what if you previously structured your organization as an LLC and not a nonprofit? In order to file for tax exempt status through section 501(c)(3), you will have to convert your business to a 501(c)(3) eligible nonprofit using the following steps.
- Step 1: Brush up on your state’s laws regarding nonprofit status. Most states require LLC managing members to vote unanimously to convert to a nonprofit corporation.
- Step 2: File an Articles of Incorporation.
- Step 3: Depending on your state’s law, you may need to include additional documents, like executed Articles of Conversion. Check with your state’s regulating agency for more information.
- Step 4: Create a nonprofit operating agreement with specific provisions and language specified in tax code Section 501(c)(3).
- Step 5: File Form 1023 with the IRS by sending the completed form and filing fee to the Internal Revenue Service, P.O. Box 12192, Covington, KY 41012-0192. The filing fee is either $400 or $800 depending on gross receipts. To calculate gross receipts take the sum of all receipts and invoices for products sold. If your gross receipts exceed the threshold of $10,000 you will pay the higher filing fee ($800).
Register with the State and File for Tax Exempt Status
If you are starting a new nonprofit, steps 3 - 5 above may apply to you when filing for tax exempt status. But before you think about filing you need to carefully consider a few things.
Registering with the State
Step 1: Determine if your organization is a trust, corporation or association before you register with the state.
A trust is created under state law and usually exists when an individual or entity holds title to a property being used for a beneficial cause. For trusts to qualify as a 501(c)(3), they must have qualifying language in the organizing documents as defined by tax code.
A corporation is formed when Articles of Incorporation are filed with the state, as directed in Step 3 of the section above. The state needs to receive the articles and sometimes a date-stamp is required, so it’s important to be familiar with your state’s laws regarding incorporation.
An association is formed when people group together for a defined purpose. Definitions of associations vary from state to state, but in order to qualify under section 501(c)(3) of tax code, the Articles of Association must contain relevant language.
Step 2: Get your documents together
Each type of organization comes with its own set of incorporating documents. These documents are specific to the type of organization requesting exempt status and without them a favorable determination cannot be made. It is wise for applicants to read tax Section 501(c)(3) carefully to understand what language needs to be included.
The types of documents to be submitted include:
- Articles of incorporation (nonprofit corporation)
- Articles of organization (LLC)
- Articles of association (association)
- Constitution of association (association)
- Trust agreement (trust)
- Declaration of trust (trust)
In addition, code 501(c)(3) requires all companies filing for exemption through this section of tax code specify the following:
- Code of Ethics
- Conflict of Interest Policy
- Document Retention and Destruction Policy
- Compensation Policy
- Joint Venture Policy
- Whistleblower Policy
Step 3: Determine state registration requirements by navigating to your state on the IRS website.
Step 4: Apply for an EIN number.
Filing Under 501(c)(3)
Now that you’ve registered with your state and believe your business is eligible to file for exemption under 501(c)(3), what’s next? You’ll have to fill out a 1023-EZ or 1023, by following the IRS instructions to determine which form is best for you.
- Step 1: Navigate to the IRS website and fill out the eligibility worksheet for 1023-EZ.
- Step 2: If eligible, proceed to the next step. If your organization is not eligible for form 1023-EZ, you may still file a 1023 and send it with filing fee to the IRS at Internal Revenue Service, P.O. Box 12192, Covington, KY 41012-0192.
- Step 3: Those eligible for 1023-EZ will be required to create an account at Pay.gov.
- Step 4: Search for “1023-EZ” in the Pay.gov search box.
- Step 5: Complete the form.
Tax Burden of Exempt Organizations
Becoming a legally recognized tax exempt 501(c)(3) organization has many benefits. These include removal of the requirement to pay federal taxes on sales and purchases, eligibility to deduct charitable gifts and waiving the Federal Unemployment Tax Act requirement (FUTA).
But nonprofit organizations with tax exemption still have to pay some taxes. Here’s what you can expect if you are an organization with employees.
If a 501(c)(3) nonprofit has employees it is usually responsible for three types of employment taxes:
- Federal Income Tax Withholding (FITW)
- Social Security and Medicare (FICA)
- State taxes not covered under exemption
Tax-exempt organizations, perhaps more than others, have critical responsibilities when navigating these taxes.
Employers are responsible for withholding federal income taxes from employee wages. To figure out how to calculate Federal Income Tax Withholding start by calculating gross pay.
- For hourly employees, gross pay is calculated as hours worked x wage. If overtime is included, the overtime must be calculated separately and added to the total.
- For salaried employees, gross pay is calculated as annual salary / number of pay periods in a year.
Once gross pay has been calculated, you need to understand how much to deduct based on an employee's W-4. Three important areas must be filled out:
- Marital status
- Number of allowances
- Additional deductions
Using this table offered by the IRS, determine how much to withhold from each paycheck based on earnings, allowances and deductions.
FICA includes both social security and medicare taxes that all employees have to pay. Social security provides funds to the elderly and survivors, while Medicare is a federal health insurance program that helps buffer hospital costs and medical fees for the same group and others who qualify.
The total amount assessed for FICA is 15.3%. Half of which is paid by employers. Both employees and employers at tax exempt organizations are required to pay their share of FICA. To calculate the total amount to be withheld, use this calculation:
- (gross pay x 0.153) / 2 = FICA Withholding
- Employers will be expected to match the same amount
State and Local Employment Taxes
Many states assess state and local employment taxes that supercede a company’s federal exempt status. This requires business owners to be familiar with the laws in their state as they apply to taxation. It may require more research on the part of each business owner to ensure they are living up to their responsibilities as a business with exemption status.
Next Steps: NonProfit Outsourced Accounting Services
Tax exempt status is a highly sought after status reserved mainly for businesses who have a lot to offer their local community in terms of resources, knowledge, charity and faith. While making a profit is not a nonprofit's primary function, it is important to an organization's health and continued success that revenues consistently exceed expenses.
Therefore, non-profit accounting must become an important part of any organization's operations. However, because accounting for non-profit organizations can be confusing to someone who isn't a certified non-profit accountant, many organizations choose to use outsourced accounting services similar to those offered by Ignite Spot.
The United States Generally Accepted Accounting Practices, or US GAAP, put into place and occasionally updated by the Financial Accounting Standards Board (FASB), require that nonprofits issue certain kinds of financial statements. Whereas accounting for a small business or firm typically involves a balance sheet, in nonprofit accounting, there is something called a statement of financial position. Just like a business's balance sheet, the statement of financial position lists an organization's assets and liabilities. The structure of the statement is based on the basic accounting equation, expressed as Assets = Liabilities + Net Assets.
Other required financial statements include a statement of activities (outlining expenses and revenues) as well as a statement of cash flow.
If you operate a religious, charitable, educational organization or other type of 501(c)(3), be sure to contact our team at Ignite Spot to see how our outsourced accounting services can save you time and money.
To get a copy of our Outsourced Accounting Guide click to download below: