WHAT IS A NONPROFIT 501C3?

A 501C3 IS AN IRS DESIGNATED TAX-EXEMPT CHARITABLE ORGANIZATION

In other words, a nonprofit organization is not required to pay federal income taxes.

More in depth, a 501c3 is a nonprofit corporation considered by the IRS to be either a “public charity” or a “private foundation” under section 501(c)(3) of the Internal Revenue Code. Upon filing the required documents and receiving IRS tax-exempt status, such an organization is tax-exempt, meaning that it is not required to pay taxes on donations made to it, or even on certain forms of income made by the organization.

501c3 organizations are split into two categories: public charities and private foundations. Public charities are much more common – and generally more desirable – so we’ll start with those and address private foundations in a moment.

Obtaining your 501c3 Tax-Exempt Status:

How hard is it to obtain 501c3 approval? And how long does it take to register as a 501c3 organization?

Normally, obtaining 501c3 approval is a long and involved process beginning with forming a board of directors, filing articles of incorporation with your state, drafting and adopting bylaws, voting in the nonprofit officers, adopting a conflict of interest policy, completing the IRS 501c3 application, including a projection of your financial data for the nonprofit’s first three years, and much more.

However, with the help of a CPA Eric J Rogers and his 30+ years of experience and helping more than 2,500+ nonprofits do just that, turning your charitable dreams into a registered 501c3 will be an easy step by step process.

The earlier you start, the better! The IRS processing times for 501c3 applications have been notoriously long, ranging from 6-10 months. And making a mistake as a result of trying to do it yourself can cost you months more in delays as the IRS sorts out the information they need or just denies tax-exempt status to your organization. However, with our new system following a new system with the IRS, we have found that most clients get their tax-exempt status in 2-3 months. It still varies with the IRS backlog, time of year, and how complicated your 501c3 application is.

The good news is, once you receive that 501c3 approval letter from the IRS, your tax-exempt status is retroactive to the date of your filing articles of incorporation in your state, meaning any contributions received after that point are tax-exempt for your organization and tax-deductible for the donors.

What is a 501c3?

Benefits of a 501c3 Public Charity:

***Public charity: Organizations that are exempt under section 501(c)(3) and are not private foundations because they are: churches, schools, hospitals, governmental units, entities that undertake testing for public safety; organizations that have broad financial support from the general public; or organizations that support one or more other organizations that are themselves classified as public charities. Public charity status is a more favorable tax status than private foundation status.

Obtaining 501c3 tax-exempt status is one of the best actions you can take for your charitable organization. Not only will donations to the nonprofit be tax-exempt, but they will also be tax-deductible for the donors, meaning donors will be significantly more motivated to give to your charity.

Moreover, income from business sources related to the organization’s tax-exempt purpose is also tax-exempt. For example, an organization could teach homeless individuals how to paint, and later could sell their paintings to others. The income from selling the paintings would be directly related to the exempt purpose of the organization–rehabilitating homeless individuals through painting workshops–and so would not be taxed income. Note that unrelated business income, such as this organization also running a for-profit art gallery (separate from their selling of the paintings by the homeless individuals), is generally taxed if grossing more than $1,000 annually.

Registered 501c3 organizations are also perceived as more credible by potential donors. Donors, especially those with large donations to make, want to be sure that their money will be used wisely and effectively to support the cause toward which they are donating. Registering as a 501c3 indicates that your charitable work has been approved of by an impartial governmental agency (the Internal Revenue Service), and that you have taken certain required steps such as establishing a board of directors.

In addition, grant-making foundations will usually refuse to make a grant to an organization that is not a registered 501c3. Because these situations frequently involve large sources of funding for nonprofits, it is very beneficial to obtain your 501c3 status early.

Disadvantages of a 501c3 Public Charity:

Are there any negatives to being a registered 501c3? Tax-exempt organizations do face compliance-related required filings every year, as well as the responsibility to maintain records such as receipts and records of contributions received. Moreover, 501c3 organizations cannot generally engage in political activity, and officers and directors are limited to reasonable salaries.

These considerations, however, amount to basic principles of bookkeeping, and of charitable work. Thus, if your goal is to make a political impact or to make a personal profit, a public charity may not be for you. Otherwise, public charities are the perfect vehicle for turning your charitable dreams into a reality that will be well-respected and well-funded.

Let’s take a look at 501c3 compliance issues.

Compliance for 501c3 Public Charities:

501c3 compliance is relatively basic, but extremely important. Many organizations, as discussed further below, are only required to file a very simple electronic form. However, even for these organizations, the consequences of failing to file are great: any organization required to file an annual return and failing to do so for three consecutive years will be subject to losing their tax-exempt status entirely. This results in another time-consuming and expensive process to regain 501c3 status.

Annual Exempt Organization filings for 501c3 organizations. All tax-exempt organizations (with the exception of churches and certain church-affiliated organizations) must file an annual return with the IRS. This keeps the IRS informed on the activities and financial status of the nonprofit, and helps them ensure that tax-exempt organizations remain charitable in nature, rather than slowly morphing into tax-exempt for-profit businesses.

Most organizations will use Form 990 or a variant for this purpose. Small organizations, defined by the IRS as “those whose gross receipts are normally $50,000 or less,” are permitted to file a very simple online form. Larger organizations, however, will be required to submit more detailed information.

501c3 organizations with more than $1,000 in unrelated business income will also need to file Form 990-T and pay taxes on this income. Moreover, all organizations with paid employees will need to file the appropriate forms to pay their employee taxes.

Let’s look at private foundations for a moment.

501c3 Private Foundations:

WHAT IS A PRIVATE FOUNDATION?

(YES, WE DO FAMILY FOUNDATIONS.)

A private foundation is a nonprofit organization whose directors and officers and their relatives are primary financial supporters of the organization. OR the directors and officers are insiders (family members or business associates) that wish to retain control of the nonprofit. (Otherwise, the IRS may require that a majority of the directors be unrelated by close family or business, and officers cannot be related–although often they do not.)

The IRS divides the nonprofit world into two groups—private foundations and public charities. You are assumed to be a private foundation unless you can show that you are supported in large part (at least one-third) by the general public (rather than the directors, officers, and their families). If the plan for your organization calls for general public support, you have 5-7 years to prove that indeed this is where your support comes from. Even though the directors and officers and their families give most or all of the money in the beginning (“seed money”), you can still be considered a public charity during the 501c3 application process. Do not check the private foundation or private operating foundation box at signup if your long-term plan is for public support even though you are putting in all or most of the money in the beginning. However, you can bring in unlimited amounts of public charity money and still be a private foundation if you wish, for example because you want your board to consist primarily of individuals related by family or business. BUT unless your private foundation will be giving its money to other 501c3’s (like the Bill and Melinda Gates Foundation), you will be classified as a “Private Operating Foundation” (please see below).

HERE’S WHAT THE IRS HAS TO SAY ABOUT PRIVATE FOUNDATIONS:

***Private foundations: Organizations that are exempt under section 501(c)(3) are private foundations unless they are public charities:  that is, churches, schools, hospitals, governmental units, entities that undertake testing for public safety, organizations that have broad financial support from the general public, or organizations that support one or more other organizations that are themselves classified as public charities.

How does a private foundation 501c3 differ from a public charity 501c3? A private foundation is the broader, typically less desirable, cousin of the public charity. In fact, all 501c3 organizations are initially assumed by the IRS to be private foundations, unless they prove that they meet the requirements to be upgraded to public charity status.

A private foundation is, most commonly, an organization established to take one principal source of funding and use it to advance a particular purpose by making grants to public charities that support that purpose.

Primarily, private foundations do not carry out the charitable activities themselves, but act through making grants to other 501c3 organizations, especially public charities. A typical example of a private foundation would be a family setting up a private foundation to handle one million dollars and use it to make grants to public charities established for the prevention of animal cruelty.

Advantages of a 501c3 Private Foundation:

One benefit of a private foundation is that the board of directors can be composed entirely of family members, whereas public charities sometimes are required to have a majority of unrelated members. In the above example, this would allow the funding family to maintain control over the use of its funds, rather than using a public charity, where they give over control to those running the charity.

For this reason, some organizations prefer to remain a private foundation, an action that is permitted by the IRS even in cases where the organization operates as if it were a public charity. However, this comes with a few disadvantages…

Disadvantages and Compliance for 501c3 Private Foundations:

Private foundations are prone to misuse, largely because they can easily be used for self-profiting tax evasion and investment strategies. For this reason, the IRS has developed a set of detailed rules to govern these foundations and to have certain requirements it believes will keep their operations in check.

Private foundations are required to donate a set percentage of the fair market value of their investment assets each year – generally 5%. If they fail to do so, a penalty tax will be imposed. Moreover, private foundation 501c3 organizations are taxed 1-2% on the interest from their investment assets each year.

There are also penalty taxes imposed on several other transactions, such as self-dealing transactions, certain taxable expenditures, investments which jeopardize their charitable purposes, and taxes on certain stock holdings.

Otherwise, private foundations are very similar to public charities. Donations made to them are tax-deductible, and contributions received by them are tax-exempt.

WHAT IS A PRIVATE OPERATING FOUNDATION?

***Private operating foundation: A type of private foundation that lacks general public support (although it can have public support, even be supported entirely by public support), but makes qualifying distributions directly for the active conduct of its educational, charitable, and religious purposes. “Directly for the active conduct” means that the distributions are used by the foundation itself to carry out the programs for which it is organized and operated. Grants made to assist other organizations or individuals are normally considered indirect.

Here is a way of looking at the difference between private foundations and private operating foundations: the private foundation typically makes grants to other 501c3’s, who perform the nonprofit mission, whereas the private operating foundation, on the other hand, performs the nonprofit mission itself.

This is a hybrid of a private foundation and a public charity. A private operating foundation uses at least 85% of its adjusted net income or minimum investment return (whichever is lower) for the operation of its own charitable activities. A typical example would be a museum or preservation of a historical farm, or any organization operating as a public charity but wanting to maintain family control and so remaining a private operating foundation.

A private operating foundation may seem like the best of both worlds, but it is important to remember that it comes with significantly higher regulations and the requirement that financial tests be met each year to prove it is not functioning merely as a private (non-operating) foundation (In addition to the 85% test mentioned above, a private operating foundation must meet one of three other tests each year, essentially requiring that either 65% of its assets be directly devoted to exempt purposes, or 67% of its minimum investment returns be donated directly to exempt purposes, or “substantially all of its support” be received from the general public and five or more exempt organizations that are not private foundations).

It is generally easier for a private operating foundation to obtain outside funding, especially because private foundations can satisfy their annual donation requirements discussed above by making grants to other 501c3 organizations, including to private operating foundations. Note that private operating foundations do not have this annual donation requirement – instead they must meet the tests described above.

For organizations that want to be controlled by one family, and/or funded primarily by one source, that want to carry on their own work, and might also be seeking funding from the public and from other 501c3’s, the private operating foundation may be a good idea. For those who will be controlled and/or funded by one primary source and would prefer making donations to other 501c3’s over actually performing tax-exempt activities, the private foundation will suit their interests better.

Conclusion:

So, what is a 501c3? It’s the perfect way to ensure all your funds and energy are directed into your charity rather than going through the tax and hassle of doing the same work without the 501c3 tax-exempt structure.

501c3 status will give you tax-exempt contributions, make donations tax-deductible, give you credibility and eligibility for grants, and help generate more enthusiasm in donors for the charitable work you’re already doing.

Still not clear on what a 501c3 is? Take a look at our FAQ or request a free personal consultation for more information.

Start fulfilling your dream now, fill out our online form to get the process started.