There are more than 1 million 501(c)(3) organizations, otherwise known as nonprofits, in the United States serving a variety of charitable causes. The process of becoming a nonprofit is time-consuming and should not be entered into lightly. When evaluating whether to become a 501(c)(3), consider what your organization’s goals are and how your business plans to get money. These are two factors that should assist in determining whether your organization should file to become a 501(c)(3).
Pro: Tax Exemption
The chief benefit of a 501(c)(3) is that it is generally exempt from paying tax on its income. Nonprofits are still required to pay employment taxes for its employees. Nonprofits also pay taxes on “unrelated business income.” Unrelated business income is generated by ongoing activities of the 501(c)(3) that are not related to the nonprofit’s core charitable purpose. This income is taxed regardless of whether the income is used to support the charitable purpose. So for example, if a 501(c)(3) dedicated to minimizing poverty sells computers, the revenue from those sales are taxed even if all the proceeds are used to help the poor.
Pro: Tax-Deductible Donations
Most donations made to a 501(c)(3) can be used as a tax deduction by the donor. If the donor itemizes his deductions, he can use his donations to decrease his taxable income, which in turn decreases his personal tax liability. The reason the government permits donors to deduct their donations from their income is to promote charitable giving.
Con: Registration with IRS
Applying for 501(c)(3) is a very long process and there is no guarantee that the IRS will grant nonprofit status. A prospective nonprofit must first organize as a corporation, trust, or unincorporated association. Next it must get an Employer Identification Number (EIN). Once the organization has completed these tasks it can apply for 501(c)(3) status by submitting a completed Form 1023 and registration fee to the IRS. After reviewing your application, the IRS issues a determination letter that will inform you whether you qualify as a nonprofit.
Con: No Distribution to Officers
A 501(c)(3)s is prohibited from distributing any of its proceeds to its board members and officers. While the organization can pay a reasonable salary, the remainder of the organization’s assets must be used to achieve its charitable purpose. If a 501(c)(3) transfers excess assets to, or enters into a transaction with, one its officers or board members, the person may be charged an excise tax on the proceeds as a penalty.
- Foundation Center: Frequently Asked Questions
- The Center for Non-Profits: Just What is a Non-Profit, Anyway?
- Idealist: Do Nonprofits Pay Taxes?
- Internal Revenue Service: Applying for 501(c)(3) Tax-Exempt Status
- Internal Revenue Service: Exemption Requirements – Section 501(c)(3) Organizations
- Internal Revenue Service: Intermediate Sanctions – Excess Benefit Transactions
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.