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The words nonprofit and charity go together in most people’s minds, but remember that not all nonprofits are charitable organizations. The most common examples are business and trade associations, social welfare organizations, labor organizations, political advocacy groups, fraternal societies, and social clubs. Although these nonprofits enjoy exemption from corporate income taxes, people who donate to them can’t claim a tax deduction for their contributions.

Most nonprofits, charitable or not, are incorporated organizations that are formed under the laws of the state in which they’re created. Some nonprofits have other legal structures, such as associations or trusts, but these are in the minority. The IRS grants tax-exempt status to a nonprofit after reviewing its stated purpose. (See Chapter 4 for information about incorporating and applying for a tax exemption.) Nonprofit types are identified by the section of the IRS code under which they qualify for tax-exempt status.

In this section, we provide an overview of the types of nonprofit organizations and some of the rules and regulations that you’ll be subject to if you decide to incorporate and seek tax-exempt status from the IRS. You may discover, for example, that your idea will have a better chance for success if you create a social-welfare organization – a 501(c)(4) – or a for-profit business.

Identifying nonprofits by their numbers

Nonprofit organizations can be formed under the IRS code for many reasons other than charitable ones. To give you a taste of the variety of these organizations, the following list summarizes various classes of nonprofit organizations:

❯❯ 501(c)(3): These organizations are formed for educational, scientific, literary, charitable, or religious pursuits and also to test for public safety and to prevent cruelty to children and animals. Nonprofits in this category may be classified as public charities or private foundations; the source of support for the organization usually determines the classification. Foundations are subject to additional rules and reporting requirements. This book focuses on 501(c)(3) organizations that are classified as public charities. Contributions to these organizations are tax deductible for their donors. Public charities may engage in limited lobbying. More information about lobbying can be found in the following section.

❯❯ 501(c)(4): These organizations are known as social-welfare organizations because they’re formed for the improvement of general welfare and the common good of the people. Advocacy groups tend to fall into this category because organizations with this classification are allowed more leeway to lobby legislators as a part of their mission to improve the general welfare. Contributions to these organizations aren’t deductible for the donor.

❯❯ 501(c)(5): Labor unions and agriculture and horticulture organizations formed to improve conditions for workers are in this category. These groups also may lobby for legislation.

❯❯ 501(c)(6): Business and trade associations that provide services to their members and work toward the betterment of business conditions are placed in this classification. This category includes chambers of commerce and real estate boards, for example. Again, lobbying for legislation is allowed.

❯❯ 501(c)(7): This section covers social clubs formed for recreation and pleasure. Country clubs and organizations formed around a hobby come under this classification. These organizations must be funded primarily by memberships and dues.

❯❯ 501(c)(9): This type of nonprofit is an employees’ beneficiary association that’s created to pay insurance benefits to members and their dependents. It must be voluntary, members must have a common bond through employment or a labor union, and in most cases, it must meet nondiscrimination requirements.

Several other 501(c) – type organizations are so specialized in nature that we won’t go into them here. One of our favorites is the 501(c)(13), which covers cemetery companies.

Political action committees (PACs) and parties have their own special classification, too. They’re recognized under IRS code section 527 and are organized for the purpose of electing persons to office. They have special reporting requirements and aren’t required to be incorporated. Donations to these organizations are not tax-deductible and the names of their donors must be disclosed.

To get the full flavor of the various categories of nonprofit organizations, check out the IRS website (www.irs.gov) or review IRS Publication 557.

Rules and regulations to add to your file

Entire volumes have been written about IRS regulations and laws pertaining to nonprofits. But don’t worry – we just want to give you an overview of some facts that may help you decide whether starting a 501(c)(3) nonprofit organization is your best choice.

IRS regulations can change from year to year, so be sure to look at the most recent version of IRS Publication 557 for the latest information.

Nonprofits and political activities

Nonprofits can’t campaign to support or oppose the candidacy of anyone running for an elected office. However, the stipulations on lobbying for specific legislation are less clear. In the following list, we break down the rules so you know what you can and can’t do, depending on what type of nonprofit you set up:

❯❯ Social-welfare organizations and labor unions: These organizations have more leeway when it comes to legislative lobbying than 501(c)(3) organizations do. They can engage in political intervention activity as long as it is not their primary activity. Groups that lobby must inform their members what percentage of dues they use for lobbying activities, and they can’t work toward a candidate’s election.

❯❯ Charitable organizations, or nonprofits that the IRS considers public charities under section 501(c)(3): These nonprofits may participate in some legislative lobbying if it isn’t a “substantial” part of their activities. The IRS doesn’t define the term substantial, so it determines this question on a case-by-case basis. These nonprofits can generally spend a higher portion of their budgets on lobbying activities if the organization chooses to elect the h designation (IRS Form 5768), which refers to section 501(h) of the IRS code. The IRS allows more expenditures for direct lobbying (when members of the nonprofit talk with a legislator about an issue at hand) than for grassroots lobbying (encouraging members of the general public to contact legislators to promote an opinion about a piece of legislation).

❯❯ Private foundations: Although they, too, are recognized under section 501(c)(3), these organizations may not participate in any legislative lobbying. The only exception to this rule is when pending legislation may have an impact on the foundation’s existence, tax-exempt status, powers, duties, or the deductibility of its contributions.

Penalties for engaging in too much political activity can include loss of your organization’s tax exemption. However, going deeper into the details of these laws and reporting requirements is really beyond the scope of this book. So if you’re contemplating involving your nonprofit in serious legislative activity, consult an attorney or tax specialist for advice. One place to find more information is National Council of Nonprofits. (www.councilofnonprofits.org).

The situation with churches

Churches are in a category all by themselves. The IRS doesn’t require them to file for a tax exemption, nor does it require them to file annual reports to the IRS. Some churches, however, do apply for an exemption because their social-service programs often include anything from preschools to soup kitchens. These programs seek 501(c)(3) status so they can more easily apply for foundation funding and government grants or contracts to help pay the costs of providing the services.

Churches that haven’t been officially recognized as being tax-exempt are highly unlikely to receive foundation grants or government contracts.

Taxes, taxes, taxes

Nonprofit organizations may be subject to unrelated business income tax, also known as UBIT. When a nonprofit makes $1,000 a year or more in gross income from a trade or business that’s regularly carried on and that’s unrelated to its exempt purpose, this income is taxable. In addition, some corporate sponsorship funds may be subject to UBIT if they’re perceived by the IRS as advertising dollars. IRS Publication 598 tells you all you need to know about this subject; visit www.irs.gov to take a look at this publication.

Some states exempt some nonprofits from paying state sales and use taxes. Check the laws in your state to see whether your organization is exempt from paying these taxes. The same is true of property taxes – it depends on your local jurisdiction. Your nearest tax assessor can tell you whether you have to pay property taxes.

Nonprofit employees must, of course, pay income tax on their salaries and other taxable compensation.

Nonprofits owning for-profits

Nonprofits can own for-profit businesses. We don’t recommend it, because you’re going to have enough on your plate, especially when you’re starting out, but it is possible. The business is subject to all regular taxes, just like all other for-profit businesses. Profits from the business may be distributed to the nonprofit, and the nonprofit must use them to further its goals and programs.

Very small organizations

If your nonprofit has less than $5,000 in annual revenues, it doesn’t need to apply for a tax exemption. You can even go a bit over $5,000 in a year if your average annual income over a three-year period is less than $5,000. When your income averages more than that amount, however, you have 90 days following the close of your most recent tax year to file for a tax exemption.

Even if your organization has revenues under $5,000, you may still need to file the IRS 990-N form. This form can only be filed online. Check the IRS website at www.irs.gov for the latest information about this requirement.

Nonprofit compensation

Nonprofit organizations have one common feature, regardless of their type: No board member, staff member, or other interested party can benefit from the earnings of a nonprofit. Instead, assets are forever dedicated to the purpose of the organization. If the organization dissolves, the nonprofit must transfer the assets to another organization that performs a similar function.

Just because assets are dedicated to fulfilling an organizational mission doesn’t mean that people are required to work for nonprofit organizations for free. Nonprofits can and should pay reasonable salaries to their staff members, if they have any. But keep in mind the difference between paying a salary and splitting the profits at the end of year.