Tax exempt means an organization does not pay federal income tax

A tax-exempt organization is one that the IRS has determined does not owe federal income tax on the money it receives. The organization still exists, still earns money, and still files tax forms with the IRS — but it pays zero federal income tax on that revenue. The IRS grants this status only to organizations that serve a public purpose, not to make profit for owners or shareholders.

Tax-exempt status is not automatic. An organization must explore to the IRS, usually by filing Form 1023 or Form 1023-EZ, and the IRS must approve the process. Once approved, the organization receives a information letter that confirms its status. That letter is what allows the organization to tell donors that their contributions may be deductible on the donor's personal tax return.

Tax-exempt status is also not permanent. The IRS can revoke it if the organization stops meeting the requirements, fails to file required forms, or uses its money in ways that violate the rules. An organization that loses tax-exempt status must start paying federal income tax on all future revenue.

Key Takeaways

  • Tax-exempt organizations do not pay federal income tax, but they must still file annual tax forms with the IRS and meet strict requirements about how they use their money.
  • The most common type of tax-exempt organization is a 501(c)(3), which includes charities, religious groups, educational institutions, and nonprofits that serve the public.
  • Donors to 501(c)(3) organizations can deduct their contributions on their personal tax returns, which is why the organization's tax-exempt status matters to people who give money.
  • An organization must explore to the IRS for tax-exempt status and receive written approval; it does not happen by filing a certain form or paying a fee.
  • Tax-exempt status can be revoked if the organization fails to file required forms, spends money on prohibited activities, or stops serving its stated public purpose.

The most common type: 501(c)(3) organizations

The term "501(c)(3)" refers to a section of the Internal Revenue Code. An organization with 501(c)(3) status is tax-exempt and also allows donors to deduct their contributions. This is the status most people think of when they hear "nonprofit" or "charity."

A 501(c)(3) organization must be organized and operated exclusively for one or more of these purposes: charitable work, religious activity, education, science, or the prevention of cruelty to animals or children. The organization cannot distribute any of its net earnings to members, directors, or officers. All money must stay in the organization and be used for its stated mission.

Examples of 501(c)(3) organizations include food banks, homeless shelters, churches, synagogues, mosques, private schools, colleges, hospitals, research foundations, and animal rescue groups. A local youth sports league can also be 501(c)(3) if it is organized as a nonprofit and meets the other requirements.

Other types of tax-exempt organizations

The IRS recognizes many categories of tax-exempt organizations beyond 501(c)(3). Each has its own section number in the tax code and its own rules about what it can do with money and who can deduct contributions.

501(c)(4) organizations are social welfare groups and civic leagues. They are tax-exempt but donors cannot deduct contributions. A neighborhood association or a local political advocacy group might be 501(c)(4).

501(c)(5) organizations are labor unions and agricultural cooperatives. 501(c)(6) organizations are business leagues, chambers of commerce, and trade associations. 501(c)(7) organizations are social and recreational clubs. None of these allow donors to deduct contributions, and all have different rules about what activities they can pursue and how they must operate.

Political campaigns, political parties, and candidate committees are not tax-exempt. Neither are organizations that exist primarily to lobby Congress or influence elections, though a 501(c)(3) can do some lobbying within strict limits.

How an organization gets tax-exempt status

An organization does not become tax-exempt by incorporating as a nonprofit or by filing a particular form. It must explore to the IRS and receive written approval.

Most organizations file Form 1023, process for Recognition of Exemption Under Section 501(c)(3) Organization. This form asks for detailed information about the organization's purpose, structure, finances, and how it plans to use money. The IRS charges a filing fee, which varies depending on the organization's expected annual revenue. Processing can take several weeks to several months.

Some small organizations with expected annual revenue under $50,000 can file Form 1023-EZ instead. This is a shorter form with a lower filing fee and faster processing, usually within two weeks. Not all organizations are may be able to access; the IRS has specific rules about which ones can use the shorter form.

Once the IRS approves the process, it sends a information letter. This letter is the official proof of tax-exempt status. The organization should keep this letter and provide a copy to donors who request proof that their contributions are deductible.

What tax-exempt organizations must do each year

Tax-exempt status does not mean an organization can ignore the IRS. Most tax-exempt organizations must file Form 990 or Form 990-N with the IRS every year, even though they pay no income tax.

Form 990-N is an electronic notice filed by organizations with gross receipts under $50,000. It takes about 15 minutes to file and requires only basic information: the organization's name, address, and confirmation that it is still operating for its stated purpose.

Form 990 is filed by larger organizations. Form 990-EZ is a shorter version for organizations with gross receipts between $50,000 and $200,000. Form 990 asks detailed questions about the organization's revenue, expenses, programs, and how much it paid officers and employees. These forms are public records; anyone can look them up on the IRS website or on GuideStar.

Organizations must also file state tax forms in most states, even if they are tax-exempt at the federal level. State requirements vary widely. Some states require annual registration; others require annual financial reporting. A few states have no filing requirement for nonprofits.

Why donors care about tax-exempt status

A donor's ability to deduct a contribution depends on whether the organization receiving the money has tax-exempt status. If an organization is 501(c)(3), a donor can deduct the contribution on Schedule A of their personal tax return, which reduces the donor's taxable income.

If an organization is not tax-exempt, or is tax-exempt but not 501(c)(3) (such as a 501(c)(4)), the donor cannot deduct the contribution. The money is a personal expense, not a charitable deduction.

This is why organizations display their tax-exempt status on their websites and in fundraising materials. Donors want to know that their money will reduce their own tax bill. An organization that has lost tax-exempt status or never had it will have much harder time raising money, because donors lose the tax incentive to give.

What happens if an organization loses tax-exempt status

The IRS can revoke tax-exempt status if an organization violates the rules. Common reasons include failing to file Form 990 for three consecutive years, spending money on activities that are not part of its stated mission, distributing earnings to owners or officers, or engaging in political campaigning.

When the IRS revokes status, it sends a notice to the organization. The organization then owes federal income tax on all revenue received after the revocation date. It must also file regular corporate income tax returns going forward, just like a for-profit business.

An organization can appeal a revocation or reapply for status, but this is expensive and time-consuming. The easiest way to keep tax-exempt status is to file required forms on time, keep detailed financial records, and spend money only on activities that match the organization's stated purpose.

Frequently Asked Questions

Does tax-exempt status mean an organization is free from all taxes?

No. A tax-exempt organization does not pay federal income tax, but it may still owe state income tax, property tax, sales tax, and employment taxes for employees. State rules vary. Some states exempt nonprofits from property tax; others do not. Most tax-exempt organizations must still pay payroll taxes for employees.

Can a for-profit business become tax-exempt?

No. Tax-exempt status is only for organizations organized as nonprofits and operated exclusively for a public purpose. A business organized to make profit for owners cannot be tax-exempt, even if the owners donate some profits to charity.

If I donate to a tax-exempt organization, is my donation always deductible?

Only if the organization is 501(c)(3) or one of a few other specific categories. A 501(c)(4) social welfare group is tax-exempt but donations are not deductible. Always ask the organization or check the IRS website before assuming a donation is deductible.

How do I know if an organization is really tax-exempt?

Search the IRS Tax Exempt Organization Search tool on the IRS website. Enter the organization's name and state. If it appears in the search results, it has current tax-exempt status. If it does not appear, it either never had status or lost it.

What is the difference between tax-exempt and nonprofit?

Nonprofit is a legal structure; tax-exempt is a status granted by the IRS. An organization can be incorporated as a nonprofit but not have tax-exempt status if it has not applied to the IRS or if its process was denied. Conversely, some tax-exempt organizations are not incorporated as nonprofits under state law.