Our clients serve as the hands and feet of Jesus, all over the world. It is true, you find life by giving your life away. Abundant life, in fact. As Luke records it: “It is more blessed to give than to receive.” (Acts 20:35 ESV).
The first-century church set into motion a world-wide movement on that cornerstone, the good news that through Jesus people find abundant life. (John 10:10 ESV). Unschooled, ordinary men like Peter and John became champions, raising boldness above lesser ideals of comfort and safety. (Acts 4:23–31 ESV).
And abundant joy naturally overflows in a wealth of giving. (2 Corinthians 8:1-2 ESV).
That tradition of generosity and community persists today.
Granted, the modern-day generous giver faces different obstacles, like regulation, taxation, and legal fees. And for many nonprofit organizations, a primary step is to acquire a helpful tool — the federal income tax exemption under the subsections of 501(c). What follows is an analysis toward a successful 501(c)(3) application.
Enjoy the article and feel welcome to contact me if you need a hand, as you pursue an abundant life.
Qualified to be 501(c)(3)?
While popular, tax code section 501(c)(3) does not cover all categories of exempt organizations. But we will limit our discussion to that section.
First, identify your purpose. The text of section 501(c)(3) sets forth a list of exempt purposes, including those religious, charitable, scientific, or educational. The others are: testing for public safety, literary, amateur sports competition, or prevention of cruelty to children or animals.
Here’s the quick test: is your organization both  organized and  operated for an exempt purpose?
Second, to be organized for an exempt purpose, the nonprofit should be formed as a separate legal entity, normally either a corporation, trust, or unincorporated association, with organizational documents limiting its operations exclusively to its exempt purpose.
And third, to be operated for an exempt purpose, the organization must limit certain activities:  it must restrict political campaigning,  its earnings and assets cannot unjustly enrich insiders,  it cannot benefit someone’s private interest more than insubstantially,  it cannot operate outside its exempt purpose,  it must not engage in illegal acts or violate public policy, and  it must restrict legislative activities.
Do You Need to File An Application?
Certain types of organizations, by their nature, may be considered tax exempt under section 501(c)(3) — without any application to the IRS. Namely, those are:
- Churches, including synagogues, temples, and mosques;
- Integrated auxiliaries of churches and conventions or associations of churches; and
- Any organization that has gross receipts in each taxable year of normally not more than $5,000.
And so, it is wise to ascertain whether you fit within that list, before spending your time and resources on the 501(c)(3) application. On the other hand, even those organizations, such as churches, may decide to apply to receive the IRS determination letter of exemption, in order to make their tax status certain.
Smaller-scale organizations are eligible to complete a truncated application, an application that requires substantially less information and disclosure to the IRS. That short application is the Form 1023-EZ. To be sure, an organization should examine the IRS Form 1023-EZ Eligibility Worksheet.
But, generally, those organizations eligible to use the Form 1023-EZ are those with annual gross receipts less than $50,000 and total assets less than $250,000.
Otherwise, organizations need to complete the in-depth Form 1023.
Public Charities and Private Foundations
Within the universe of 501(c)(3) organizations, there are two main categories:  public charities, and  private foundations. The IRS asks the applicant to identify as one or the other. Both are 501(c)(3) organizations, but with different tax rules. And, broadly speaking, public charity status is a more favorable tax status than private foundation status.
Specifically, tax deductions for donors are more generous for contributions to public charities. And private foundations are subject to tighter restrictions, enforced with excise taxes in the case of a violation. Namely, among others, there are restrictions on self-dealing between private foundations and certain related, “disqualified,” persons, and the IRS imposes a requirement for annual distribution of income for charitable purposes. Additionally, private foundations are subject to excise taxes on net investment income that are not imposed on public charities.
As a rule of thumb, the IRS sorts organizations into one or another based upon the organization’s sources of financial support. Public charities have a broad base of support, while private foundations receive funds from fewer sources.
By definition, the following types of organizations are public charities:
- Hospitals and medical
Additionally, so are organizations that receive “substantial support” from government funding or the general public.
The IRS defines the term “substantial support” through two tests, the “public support test” and the “facts and circumstances test.” The “public support test” looks to whether the organization receives at least 33% of its revenue from general public contributions or government or other public charities. And the “facts and circumstances test” looks at the complete picture, including sources of financial support — both now and projected — as well as other characteristics, such as the public nature of the organization’s governing body and the public nature of its operations.
There are two other predefined categories of public charities:
- Organizations that normally receive more than one-third of their support from contributions, membership fees, and gross receipts from activities related to their exempt functions, and not more than one-third of their support from gross investment income and net unrelated business income; and
- Organizations that support other public charities.
Again, organizations within these bounds are able to receive the most beneficial tax status under section 501(c)(3).
The remaining organizations are deemed to be private foundations. Under that umbrella, the most common is the grant-making (non-operating) foundation, and the other is the private operating foundation, one that actively engages in its exempt activities.
Private operating foundations hold certain tax advantages, such as higher charitable deduction limits for donors.
The legal rule: a private operating foundation is any private foundation that meets the “assets test,” the “support test,” or the “endowment test” — and it must distribute substantially all (85% or more) of the lesser of its adjusted net income or minimum investment return.
In brief, the “asset test” considers whether the foundation directly devotes substantially more than half (65% or more) of its assets to its exempt activity or owning stock to control a corporation that does. The textbook example is museums and libraries. Next, the “support test” measures the portion of capital received from the general public and other exempt organizations, versus the foundation’s gross investment income. And last, the “endowment test” requires the foundation to distribute, directly for the active conduct of its exempt function, at least two-thirds of its minimum investment return.
Another Solution: Affiliate with an Existing Organization
An organization that lacks the resources to become a stand-alone 501(c)(3) organization can also consider affiliating with an existing 501(c)(3) organization. There, the organization would piggyback on the tax-exempt status of the other, receiving many of the same benefits. One drawback, however, is that the organization looking to obtain exempt status must grant full control to the existing organization.
Time Required for the Application and Professionals
If you choose to complete the application yourself, be prepared to devote a substantial amount of time.
In its instructions, the IRS estimates according to its Paperwork Reduction Act Notice that Form 1023-EZ may require a total of 19 hours, 10 minutes to complete, and the longer Form 1023 could require 201 hours, 27 minutes. Tasks included in that estimate are: record-keeping, learning about the law and the form, preparing the form, and copying, assembling, and sending the form to the IRS.
Therefore, most organizations should team-up with legal counsel and a tax adviser, who can reduce the time and money spent on this project.
Why Obtain a 501(c)(3) Tax Exemption?
Why endure this process? In the end, a 501(c)(3) exemption is a key advantage for any nonprofit organization. Once the organization successfully navigates the maze of legal tests, categorizations, and information we’ve discussed, it adds to its credit:
- Exemption from federal income tax;
- Eligibility to receive tax-deductible charitable contributions; and
- Possible exemption from social security taxes for pastors.
The organization also may receive other intangible rewards, like the chance of increased donations, as individual and corporate donors are more likely to support organizations with 501(c)(3) status. Additionally, state and local officials may grant exemption from income, sales, or property taxes.
All things considered, the time and money to obtain a 501(c)(3) exemption is widely considered to be a worthwhile and worthy investment. And it’s one that will enable your organization to better steward the generous gifts entrusted to it.