A 501(c)(3) is a nonprofit organization that qualifies for certain tax exemptions at the federal level, and it is the most common type of nonprofit. The U.S. Department of Treasury regulates and administers these organizations through the IRS. Only certain purposes and entities qualify for 501(c)(3) status, and there are rules and regulations that must be followed to maintain 501(c)(3) status. If you’re considering setting up a 501(c)(3), it is also important to note the advantages and disadvantages.
Below, we’ll go over all of this, as well as how to obtain and maintain 501(c)(3) status.
Purposes that Qualify for 501(c)(3) Status
To obtain 501(c)(3) status, a nonprofit organization must exist for one or more of the following charitable purposes:
- Testing for public safety
- Fostering of national or international amateur sports
- Prevention of cruelty to animals and children
If your nonprofit’s purpose is not one of the above, then you will not qualify for 501(3)(c) status.
Entities that Qualify for 501(c)(3) Status
When setting up a 501(c)(3), keep in mind that these are the types of entities that can obtain such status: corporations, trusts, community chests, and LLCs. The most common type is a 501(c)(3) nonprofit corporation.
Types of 501(c)(3) Organizations
There are two major types of 501(c)(3) organizations:
Public charities that obtain 501(c)(3) status receive most of their income from the public or government, and to maintain such status they must receive at least one-third of their revenue from a broad base of public support. Individuals who donate to such charities can claim a deduction of up to 60% of their adjusted gross income when filing their taxes. Corporations that donate to public charities are capped at a deduction of 10%. Additionally, public charities typically need to have a governing body made up of individuals unrelated to the charity.
There are two types of private foundations - private non-operating foundations and private operating foundations.
- Private Non-Operation Foundation: These foundations do not usually have active programs, such as educational programs, religious programs, sports programs, etc. They are also not required to be publicly supported, and revenue may come from a small group of donors. Private foundations often support public charities through grants. Donations may be tax-deductible for individual donors up to 30% of their income. Unlike public charities, governing bodies for private foundations can be more closely held. For example, family foundations are private foundations.
- Private Operating Foundation: This is the least common type of 501(c)(3). Similar to public charities, private operating foundations operate active programs. However, unlike public charities (but similar to private non-operating foundations), they can be closely held. So, private operating foundations are like a hybrid, and most of their donations must go to active programs. The deductibility of donations is similar to public charities.
To learn more, check out our article about the Pros and Cons of forming a Private Foundation.
Rules and Regulations of 501(c)(3) Nonprofits
There are certain rules and regulations 501(c)(3) nonprofits must follow to qualify for and maintain their status:
- They can only be organized and operated for exempt purposes.
- They cannot be organized or operated for any personal interests.
- Nonprofits can make profits, but any profits must go towards charitable purposes and cannot be used for private shareholders or individuals.
- Political and lobbying activities are restricted, and only a small portion of the budget may be used for such activities 501(c)(3)s are prohibited from donating to any political campaigns or endorsing any candidates.
- Most states require nonprofits to register with the state before they can solicit donations.
- Most states recognize 501(c)(3)s as valid for state tax exemptions, but some, such as California and Texas, have their own review process for charitable status.
- If a 501(c)(3) is dissolved, any assets must transfer to another 501(c)(3).
- 501(c)(3)s must also follow Public Disclosure rules.
Advantages and Disadvantages of a 501(c)(3)
There are many advantages of obtaining 501(c)(3) status for your nonprofit:
- One of the most well-known advantages of 501(c)(3) status is the federal tax exemption.
- Donations to 501(c)(3)s offer tax deductions to both individuals and corporations.
- Many states allow nonprofits to apply for sales tax exemption on items purchased and used by the organization.
- Many states also offer property tax exemption for 501(c)(3) nonprofits.
- The United States Postal Service offers discounted bulk rates for stamps for 501(c)(3)s.
- Other discounts are often also offered to 501(c)(3) nonprofits, including discounted rates on advertising.
- 501(c)(3)s can receive grants from foundations and the government.
- 501(c)(3)s typically benefit from limited liability protection since they are usually set up as corporations or LLCs.
There are also certain disadvantages that come with 501(c)(3) status:
- One major downside is that profits cannot be shared with directors, officers, or staff members.
- Activities to generate income are limited.
- The IRS heavily scrutinizes any unrelated income.
- If a 501(c)(3) shuts down, then all assets must be transferred to another 501(c)(3).
How Do You Obtain 501(c)(3) Status?
Obtaining 501(c)(3) status is simple. Follow these steps to set up your 501(c)(3) nonprofit:
1) Decide on the purpose of your nonprofit: Remember that to qualify for 501(c)(3) status, your nonprofit must operate for the charitable purposes of religion, charity, science, public safety testing, literacy, education, fostering national or international amateur sports, or prevention of animal or child abuse. Be clear on this purpose and your mission. A clear purpose also motivates volunteers and encourages donor support.
2) Choose a name: Choosing a name is important because it becomes part of your brand and how people know you. When deciding on a name, be sure to choose one that is not the same as or too similar to an existing entity. You can do this by searching your state’s business name database and the U.S. Patent & Trademark Office’s trademarks. It is also a good idea to search existing DBAs (doing business as – sometimes known as a trade name, fictitious name, assumed name, etc.) in your state just to be sure that a name hasn’t been reserved, even if it is not yet used by a business.
3) Form your business entity: You must form one of the business entities listed above as to qualify for 501(c)(3) status. Most people choose to form a corporation, but an LLC is another option, as are trusts or community chests. When you register your business with your state, be sure to include the required specific language to ensure that you will be able to obtain tax exemption status. You can check the IRS website for this.
4) File a 501(c)(3) tax exemption application: Once you have filed your articles of incorporation (or another appropriate form of state business registration), you can submit a federal 501(c)(3) tax exemption application along with a copy of your articles of incorporation. You will need to fill out IRS Form 1023. Smaller nonprofits may be able to file 1023-EZ, which is a simpler and shorter application form. Check the IRS website to find out whether you are eligible for this application form. Either way, if you have any questions or need help filling out your forms, be sure to consult an attorney.
5) Apply for state tax exemption: Some states, but not all, require you to file a separate state tax exemption application to determine your eligibility. Other states automatically accept 501(c)(3) status for state tax exemption. Be sure to check with your state’s business office to determine their requirements to receive state tax exemption as a nonprofit.
6) Draft your bylaws: Like with a regular corporation, you will need to draft your bylaws. These are the internal governing rules that lay out rules and procedures for holding meetings, voting on actions, and electing directors and officers. The bylaws are usually approved at the first board meeting.
7) Appoint directors: The directors of a nonprofit make major policy and financial decisions. Some states allow for just one director, while others require a minimum of three, so be sure to check with your state board of directors requirements. Consider selecting directors from different backgrounds and with different expertise to help you with all the potential needs of your nonprofit. You may also consider selecting your board of directors before incorporating, as some may be able to help with the filing process. Some states require you to list the names of your board members.
8) Hold your first board meeting: At the first board meeting, the board of directors will adopt the bylaws, appoint officers, record the receipt of federal and state tax exemption, and address any other important issues. Minutes for the meeting should be recorded and filed in the nonprofit’s records.
9) Maintain good standing and compliance: Be sure to maintain good records and file annual reports as required by your state and the IRS. Also, remember to comply with any required rules and regulations to ensure that you do not lose your status.
How Do You Maintain 501(c)(3) Status?
To maintain your 501(c)(3) status, it is important to make sure you maintain good records, file annual reports in a timely manner, and comply with rules and regulations required of 501(c)(3) nonprofits.
A 501(c)(3) must maintain records that show it complies with tax exemption rules. There are four different types of financial records you will want to keep:
- Money coming in: Keep track of all the money that comes into your organization, including cash register receipts, bank deposit slips, receipt books, invoices, credit card slips, and any Form 1099-MISC you send to the IRS. You’ll want to save these records for three years after the date that the return is due or filed, whichever is later. Keep in mind that some interested parties such as grantors, insurance companies, creditors, or state agencies may require you to hold on to records for a longer period.
- Money going out: Money going out covers any expenses of the organization. Records will include statements, canceled checks, cash register receipts, credit card sales slips, invoices, and petty cash slips. Same as above, these records should be kept for at least three years after the date that the return is due or filed, whichever is later.
- Employment tax records: Employment tax records include documents that show salaries, wages, benefits paid, and taxes withheld. These records should be kept for at least four years.
- Asset records: Be sure to maintain records showing what assets your nonprofit owns, such as buildings, furniture, or investments. Such records should show when an asset was purchased, any debt used to purchase it, the purchase price, the sale price, the expense of selling it, the cost of any improvements, deductions taken for any depreciation or destruction of the asset, how the asset is or was used, and when and how the asset was disposed of.
Most states require you to file an annual report, and you will also need to file a federal report. For state filings, there are typically four types: corporate filings, financial filings, fundraising registrations, and state tax exemption filings. Federal filings require that you annually file Form 990. If you run a small nonprofit with annual receipts less than $50,000, you may use Form 990-N.
Comply with Rules and Regulations
Remember to stay within the rules and regulations of 501(c)(3)s to maintain your status. Avoid activities involving politics and lobbying, operate within the allowed purposes, and ensure that profits do not fall into personal pockets. Complying with the rules and regulations of 501(c)(3)s will help you maintain your status.
Want to learn more?
To learn more about the records that your 501(c)(3) nonprofit will need, you can read our article here.