The Internal Revenue Service exempts certain kinds of organizations from income taxes, but it imposes specific requirements to maintain this preferential treatment. The 501(c)(3) status is the most highly sought form of nonprofit designation because it allows the organization to receive tax-deductible donations. To achieve this status, an organization must engage exclusively in specific public activities and cannot generate profits for its owners. It also must keep detailed records.
A 501(c)(3) corporation is incorporated under its state laws, or organized as a trust or association, and has applied for tax-exempt status from the IRS. The basic requirements for this exemption are exclusive operation for designated exempt purposes and reinvestment of profits in activities related to these exempt purposes.
According to the IRS, the exempt purposes permitted under 501(c)(3) are "charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals." "Charitable" is used here in a generic sense to mean activities that serve a broad range of public purposes, such as helping the poor, eliminating discrimination and erecting public buildings.
By definition, a 501(c)(3) must engage in activities related to exempt activities "exclusively." In practice, the organization is permitted to engage in non-exempt activities as long as they constitute only an insignificant amount of the total activities and revenues. As the percent of its total income derived from non-exempt activities increases, the organization must be able to account for this (such as by increasing spending on exempt activities) or risk losing its tax-exempt status.
The other major restriction on 501(c)(3) companies is on profit. Income in excess of operating expenses cannot go to the owners as profit. Instead it must be reinvested into activities related to the exempt purposes. Employees of a 501(c)(3) corporation can be compensated according to standard market rates.
An organization must apply for 501(c)(3) status by filing IRS Form 1023 unless it is a church or public charity that takes in less than $5,000. This must occur within 27 months from the date of its formation for tax-exempt status to apply retroactively. The organization must file an annual tax return (Form 990) if its annual receipts exceed $25,000. A 501(c)(3) must keep careful financial records because it can lose its tax exemption if it's audited and cannot document its financial condition.