The terminology used to describe nonprofit, tax-exempt organizations often generates much confusion. Consequently, it is useful to clarify two key terms. Nonprofit entities are generally organized and operated as both nonprofit and tax-exempt entities. “Nonprofit” status refers to incorporation status under state corporate law; “tax-exempt” status refers to federal income tax exemption under the Internal Revenue Code (“IRC”).
Note that the key distinction between nonprofit and for-profit corporations is that while for-profits have owners/shareholders, nonprofits do not.
One who doesn't know otherwise might reasonably conclude that as nonprofit, tax-exempt entities, such organizations may not earn profits (realize more income than expenditures) and that they need not pay any taxes. Neither conclusion is correct.
Nonprofits are permitted to generate greater income than expenses and still retain their nonprofit corporate status. However, nonprofit corporations are barred from distributing their net earnings to individuals who control the organizations. Similarly, they are barred from accumulating equity appreciation for private benefit. Nonprofit organizations have chosen to undertake programs and activities to benefit the public – or, for example, in the case of trade and professional associations, an industry or profession – rather than private individuals. Their earnings must therefore be dedicated to furthering the purposes for which they were organized. Nonprofit organizations have no owners and pay no dividends; all earnings are reinvested in the entity in furtherance of its nonprofit mission and purposes.
Nonprofits in the United States are governed by the nonprofit corporation statute in their state of incorporation (or the District of Columbia) – not the state in which their office(s) is/are located. The nonprofit corporation laws are enforced by state Attorneys General.
Most nonprofits are also tax-exempt entities, but they need not be. Taxable nonprofit corporations do exist, usually because they would not – or choose not to – qualify for recognition of federal tax-exempt status. These entities are few and far between. Most nonprofit organizations qualify for federal income tax exemption under one of approximately 30 subsections of Section 501(c) of the Internal Revenue Code.
The vast majority of all nonprofits in the United States (including charities and foundations as well as educational, healthcare, religious, and arts and cultural institutions) are tax-exempt under IRC Section 501(c)(3). Other common categories of federal tax-exempt status are Sections 501(c)(4) social welfare organizations, 501(c)(5) labor and agricultural organizations, 501(c)(6) trade and professional associations and chambers of commerce, and 527 political organizations. In addition, it is common for an entity exempt from tax under one category of the IRC to have a controlled affiliate under a different category of federal tax exemption, such as 501(c)(6) associations with 501(c)(3) related foundations and 501(c)(3) charities with 501(c)(4) advocacy affiliates, and even to own (in whole or in part) taxable subsidiaries.
But what does tax exemption mean? Does it mean that an organization is exempt from all taxes? No. Tax-exempt status means that an organization is exempt from paying federal corporate income tax on income generated from activities that are substantially related to the purposes for which the entity was organized (i.e., to the purposes for which the organization was recognized by the Internal Revenue Service (“IRS”) as tax-exempt). The organization must, however, pay federal corporate income tax (currently at a flat 21% tax rate) on income from regularly carried on business activities which are unrelated to its tax-exempt purposes, called unrelated business income (“UBI”). The most common form of UBI is advertising income. Tax-exempt entities are limited in how much UBI they can earn without putting their tax-exempt status in jeopardy.
Organizations that meet the requirements for federal tax exemption can generally rely on that status to exempt their income from state corporate income tax in the state in which their principal office is located.
For more information, contact the author at jtenenbaum@TenenbaumLegal.com.