When for-profit and nonprofit companies are incorporated, they must choose a legal structure (corporation, limited liability company, partnership, and sole proprietorship are the primary options available) and, in some cases where the option isn’t fixed, a taxation structure. For example, limited liability companies may choose to be taxed personally or at the corporate level. Although most LLCs are treated as pass-through organizations, they may opt to be taxed as corporations. Nonprofit organizations have the unique option of being classified as tax-exempt.
Most commonly, nonprofit organizations choose to be categorized as 501c3 organizations. As a 501c3 nonprofit organization, a company is generally considered exempt from most kinds of federal income tax, including taxation related to gains on sales, income, and capital gains taxes on certain securities. More than 30 distinct kinds of nonprofit organizations are considered exempt from many (if not most) kinds of federal income taxation when they are classified as 501c organizations. Only certain nonprofit organizations are eligible to be categorized as 501c3 nonprofit organizations specifically.
Organizing a 501c3 Nonprofit Organization
501c3 organizations are often referred to as “charitable organizations” because they generally must serve a charitable purpose. According to the Internal Revenue Code, a 501c3 organization must be organized and operated exclusively for an exempt purpose. Permissible exempt purposes are restricted to those that are:
- testing for public safety
- fostering amateur sports competition
- preventing cruelty to children or animals
In addition to being organized and operating exclusively for one of the above-noted exempt purposes, a 501c3 organization must also not serve as an “action organization” (it cannot participate in campaign activities directed to support or oppose political candidates and a substantial focus of its activities cannot center on influencing legislation) and none of its earnings may “inure to any private shareholder or individual,” according to IRS restrictions. Finally, a 501c3 organization cannot be organized or operated for the benefit of private interests.
Forming a 501c3 Nonprofit Organization
Once a 501c3 organization is properly formed and recognized, its activities are largely exempt from federal income taxation and a host of other federal, state and local tax requirements. Additionally, 501c3 organizations are eligible to receive tax-deductible contributions to their efforts (with the exception of those 501c3 organizations operating for the purpose of testing for public safety). 501c3 organizations are also eligible to apply for grant funding from the government and private foundations.
Any nonprofit organization that does not meet 501c3 requirements may be classified under an alternative section of the Tax Code. Just because a nonprofit organization can’t be recognized under Section 501c3 doesn’t mean it can’t enjoy tax benefits under a different Tax Code categorization. The following are other common examples of nonprofit organizations taxed under alternative subsections of the broader 501c Section of the Tax Code:
501c4 – Civic Leagues, Social Welfare Organizations, and Local Associations of Employees
501c5 – Labor, Agricultural, and Horticultural Organizations
501c6 – Business Leagues, Chambers of Commerce, Real Estate Boards, etc.
501c7 – Social and Recreational Clubs
501c8 – Fraternal Beneficiary Societies and Associations
501c9 – Voluntary Employees Beneficiary Associations
501c10 – Domestic Fraternal Societies and Associations
501c19 – Post or Organization of Past or Present Members of the Armed Forces
Public vs. Private
If the founder(s) of a nonprofit organization is interested in pursuing tax-exempt status under Section 501c3 of the Tax Code, that founder(s) will need to choose between classification as a public charity and a private foundation. Humorously, the Internal Revenue Service defines a public charity essentially as “not a private foundation.” However, more nuanced criteria do ultimately apply to private charities. Public charities must be funded primarily by government grants and/or support from the general public.
By contrast, private foundations may be financed primarily by a single family, a few families, or even a single individual. If you are thinking about starting a nonprofit and your funding will come primarily from endowments and private investments (as opposed to public support and government funding), you’re likely going to need to structure your 501c3 organization as a private foundation. Should you choose to operate a private foundation, you’ll need to specify whether it will function as “operating” or “nonoperating.” Operating foundations craft their own programming, whereas nonoperating foundations serve primarily as a means to finance the operations of other nonprofit organizations.
501C3 Legal Guidance Is Available
If you’re interested in founding a nonprofit organization, under Section 501c3 of the Tax Code or another applicable designation, please consider scheduling a consultation with us today. Our attorneys have extensive experience assisting both for-profit and nonprofit startup founders realize their visions. Our attorneys understand what new businesses and organizations need in order to launch successfully. We look forward to speaking with you.