Part 1: Starting with an Idea

Nonprofit organizations have always been a unique feature of American society. In the 1830s, the French traveler Alexis de Tocqueville observed how everyday Americans formed charitable associations to accomplish things that had traditionally been reserved for the rich and powerful in Europe.¹ Almost two centuries later, de Tocqueville’s observations still hold true. In 2016 alone, over 1.5 million new nonprofits were registered with the IRS and nonprofits made up nearly 6% of the U.S. GDP.² Supporting the tradition of charitable enterprise in America, federal and state governments have historically exempted such organizations from taxation, including sales tax, property tax, and income tax. They have also provided tax incentives to individuals to encourage charitable donations.

This series of articles on nonprofit formation is designed to inform and encourage those who are considering forming a nonprofit organization. In this first installment, we will discuss the basics of tax-exempt nonprofit organizations, what they are, and what they can and cannot do. This series starts on this topic because it is foundational for taking the first steps toward forming a nonprofit.

Understanding the Difference Between “Nonprofit” and “501(c)(3)”

Although the terms “nonprofit" and “501(c)(3)” are often used interchangeably, they refer to two distinct categories that often overlap. A nonprofit corporation, like any other private legal entity, is created by state law. A corporation is an entity and has a separate legal identity from its incorporators. It is a “person” in the eyes of the law, meaning that it can sue or be sued, buy or sell property, and enter into contracts. Its liabilities and assets are distinct from those of the individuals who operate it.³

The unique characteristic of a nonprofit corporation is that it does not have owners or shareholders. Both a for-profit corporation and a nonprofit corporation can make money. The difference is that with the for-profit corporation, the profits flow to owners/shareholders, but nonprofits technically have no “owners.” A non-profit’s revenues and assets can go towards paying for its operational expenses (e.g., overhead costs, employee salaries, etc.). Excess must be invested back into the nonprofit or donated to another charity.

The term “501(c)(3) organization” refers to an organization that is determined by the IRS to be tax-exempt under the statute 26 U.S.C. § 501(c)(3). Just because an organization is a nonprofit (i.e., formed as a nonprofit on the state level), does not necessarily mean that it is a 501(c)(3) organization. Unless a nonprofit organization is a church or an “integrated auxiliary of a church”⁴ (both of which automatically have tax-exempt status), it will need to apply for tax exempt recognition and receive a formal determination of exemption from the IRS in order to be exempt from federal income taxes and for its donors to deduct contributions on their own personal tax returns.

So all 501(c)(3)s are nonprofits, but not all nonprofits are 501(c)(3)s. Nonprofit status is a form of entity under state law, and 501(c)(3) status is a tax-exempt recognition under federal law.

Exempt Purposes and Activities

Section 501(c)(3) of the tax code states that in order to be tax-exempt, a nonprofit corporation must be organized and operated exclusively for one of the following purposes:

• Religious purposes
• Charitable purposes⁵
• Scientific purposes
• Testing for public safety
• Literary purposes
• Educational purposes
• Fostering national or international amateur sports competition
• Preventing cruelty to children or animals

Although there are other categories of tax-exempt organizations under Section 501, this series focuses on nonprofit organizations under 501(c)(3), since those are the most common.

If you want to form a nonprofit and successfully apply for tax-exempt recognition from the IRS, then all of the purposes and activities of your organization must fit into one or more of the categories listed above. If your organization has or will have operations that are outside of these categories, then those non-exempt activities may require paying taxes on unrelated business income, or even disqualify it from tax-exempt status altogether.

In addition to the requirement that an organization must have exempt purposes and activities, Section 501(c)(3) requires that no part of an organization’s net earnings may benefit any particular private parties, and also that the organization’s activities cannot include political lobbying or campaigning. We will discuss these restrictions in more detail in a subsequent installment in this series.

The first question you should ask when deciding to form a nonprofit is whether your organization’s proposed purposes and activities fit into would be recognized as tax-exempt under section 501(c)(3).

Stay Tuned

In our next installment in this series on nonprofit formation, we will discuss the first steps you will need to take after you have an idea for an organization that is within the scope of exempt purposes and activities. These steps include selecting your directors and officers, drawing up your organization’s governance documents (articles of incorporation, bylaws, initial policies, etc.), and forming your organization on the state level.

In Part 3, we will discuss the different categories of nonprofit organizations that the IRS recognizes as tax-exempt under 501(c)(3) (private foundations vs. public charities) and how to decide which is right for your enterprise. In Part 4, we will look at restrictions on private inurement and political activities and how to avoid getting into trouble with the IRS on those issues. Finally, in Part 5, we will examine the process of applying for 501(c)(3) status and how to maintain that status going forward.

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¹ Alexis de Tocqueville, Democracy in America, Edited and translated by Harvey C. Mansfield and Delba Winthrop (University of Chicago Press, 2000) p. 489.

² See National Center for Charitable Statistics, The Nonprofit Sector in Brief 2019, June 2020.

³ Nonprofit organizations most commonly form as corporations, but they can take other entity forms such as trusts, LLCs, or unincorporated associations.

⁴ The term “integrated auxiliary of a church” refers to a class of organizations that are related to a church or convention or association of churches, but are not such organizations themselves.

⁵ According to the IRS, “the term charitable is used in its generally accepted legal sense and includes relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.”

Featured Image by Rebecca Sidebotham.