Many nonprofit organizations intend to apply for 501(c)(3) tax-exempt status. Section 501(c)(3) of the Internal Revenue Code exempts organizations that meet its requirements from paying federal income taxes on accumulated surplus (money that in the for-profit world would be referred to as “profits”). Under North Carolina law, organizations that meet the requirements of Section 501(c)(3) are also exempt from paying state corporate income tax.
4.1 – IRS Forms and Requirements
Organizations apply for Section 501(c)(3) tax-exempt status using Form 1023, Form 1023A, or Form 1023-EZ. The Form 1023 is the default form to apply for Section 501(c)(3) tax-exempt status. The Form 1023-EZ is a streamlined form available to organizations that meet certain qualifications. To determine eligibility, all organizations must fill out the Form 1023-EZ Eligibility Worksheet prior to completing Form 1023-EZ.
4.2 – Form 1023 Prerequisites
Larger nonprofit organizations must complete Form 1023 to apply for Section 501(c)(3) tax-exempt status. Prior to completing Form 1023, the organization must complete certain Form 1023 prerequisites. They include:
- ensuring that the organization is properly organized as a nonprofit corporation, charitable trust, or unincorporated association;
- applying for and receiving an EIN number;
- obtaining copies of each organizing document (including the articles of incorporation and bylaws) to accompany the Form 1023; and
- ensuring that the organizing documents contain required charitable purpose and dissolution clauses.
4.3 – Completing the Form 1023-EZ
Form 1023-EZ is a streamlined version of Form 1023 available to smaller organizations. Among other requirements, Form 1023-EZ is only available to organizations that have annual projected gross receipts of less than $50,000 for each of the next three years, and total assets of less than $250,000. It is much easier to complete than Form 1023 and requires little information from applicants. Applicants must provide their contact information and EIN. The reminder of the form requires only that applicants check yes or no to certain questions about their corporate documents and planned activities.
4.4 – Completing Form 1023
Once a nonprofit organization has completed the prerequisites, it may apply for 501(c)(3) tax-exempt status using Form 1023. Many sections of Form 1023 are clearly explained in the instructions to the form. The following discussion highlights a few areas that are tricky, complicated, or particularly important.
4.4.1 – Identification of the Applicant
Part I of Form 1023 asks for identification information of the organization, including the organization’s EIN number. Part I also asks if the organization claims to be exempt from filing Form 990 or Form 990-EZ. The vast majority of organizations are required to file those forms, so the answer to the question will be “no.”
4.4.2 – Organizational Structure
Part II asks about the form of entity of the organization. To apply for 501(c)(3) tax-exempt status, a nonprofit organization must be organized as a nonprofit corporation, charitable trust, or unincorporated association.
Practice Tip. Make sure the organization’s website listed in Part I is consistent with what the organization says about itself in the Form 1023. The IRS examining officer will almost certainly examine the website carefully.
4.4.3 – The Organizational Test
Part III of Form 1023 is referred to as the organizational test. All applicants for 501(c)(3) tax-exempt status must include certain language in their organizing documents (normally their articles of incorporation) that states their exempt purposes and requires that upon dissolution all of the applicant’s assets will be donated to another 501(c)(3) (or a governmental entity) and will continue to be used exclusively for an exempt purpose. To comply with Part III’s requirements, attach the North Carolina Secretary of State’s Tax Exempt Status Information Form to the articles of incorporation.
4.4.4 – Narrative Description of the Organization’s Activities
Part IV of Form 1023 requires a narrative description of the organization’s planned activities. To be approved for 501(c)(3) tax-exempt status, the organization must convince the IRS that it will be operated primarily for an exempt purpose such as education or aiding the poor and distressed.
Practice Tip. The narrative description of activities is the heart of the Form 1023 application. The IRS examining officer will almost certainly read this section first, and based on what he or she sees, will decide how closely to scrutinize the rest of the application. The drafting attorney should take great care to make sure the narrative is comprehensive, clear, and succinct.
4.4.5 – Compensation of Insiders
Part V of Form 1023 requires disclosure of the names, titles, and addresses of all officers, directors, trustees, as well as the organization’s five highest paid employees and independent contractors that receive or will receive compensation of more than $50,000 per year. For each, the applicant must disclose annual compensation.
Part V also asks questions that determine whether the earnings of the organization inure to insiders in the organization. The section asks whether the organization has and follows a written conflict of interest policy, whether directors and officers are related to each other through family or business, and how directors will set compensation for directors, officers, and highly paid employees and independent contractors. Finally, Part V requires disclosure of transactions between the organization and officers, directors, or trustees.
4.4.6 – Member or Other Individuals that Receive Benefits from the Organization
Part VI asks about the members and other beneficiaries of the applicant’s activities. To be approved, the organization’s activities must benefit a large or indefinite group of individuals. The organization should avoid activities that benefit only corporate insiders or a narrow slice of the population. For example, an organization formed to benefit the residents of a single residential street might not qualify.
4.4.7 – History of the Organization
Part VII first asks whether the applicant is a successor to another organization and has taken over the other organization’s activities. Part VII also asks whether the organization is filing Form 1023 within twenty-seven (27) months after the end of the month in which the organization was formed. If the organization files Form 1023 within twenty-seven (27) months after formation and the organization is approved for 501(c)(3) tax-exempt status, its tax-exempt status relates back to the date of incorporation. If the organization applies for tax-exempt status greater than twenty-seven (27) months after formation, however, its tax-exempt status is effective as of the filing date.
4.4.8 – Specific Activities
Part VIII asks for information about specific activities that Section 501(c)(3) tax-exempt organizations are restricted or prohibited from carrying out. These include:
- Political Campaign Activities. 501(c)(3) tax-exempt organizations are strictly prohibited for supporting or opposing candidates in political campaigns. 501(c)(3) tax-exempt organizations may participate in the following activities, however, without running afoul of the prohibition on political campaign activities:
- voter education activities, including providing a public forum for debates;
- appearances by candidates running for office at nonprofit-sponsored events, so long as each candidate is given an equal opportunity; and
- nonpartisan voter registration drives.
- Lobbying. No substantial part of a 501(c)(3) tax-exempt organization’s activities may consist of lobbying. Lobbying is defined by the IRS as efforts to directly influence members of a legislative body to vote a certain way on a particular bill, or efforts to influence the public to contact their legislators regarding a particular bill. Organizations that intend to engage in substantial lobbying activity should seek specialized legal counsel.
Practice Tip. If an organization intends to engage in political activities or significant lobbying activities, it should consider forming as a 501(c)(4) social welfare organization rather than as a 501(c)(3) organization.
- Fundraising. Part VIII of Form 1023 asks whether the applicant will undertake fundraising, the methods by which it plans to fundraise, and the states in which it plans to fundraise. Additionally, Form 1023 requires disclosure of any contracts with professional solicitation firms, and contracts to fundraise on behalf of other organizations. Finally, applicants must disclose whether they maintain separate accounts for any donor under which the donor has the right to advise on the use or distribution of the funds.
Practice Tip. The description of fundraising activities need not be overly detailed. For example, it can simply state that the organization will apply for grants from private foundations and governmental entities.
- Economic Development. Part VIII of Form 1023 also asks whether the applicant will engage in economic development. Economic development activities are permitted, but must adhere to certain guidelines to avoid being labeled commercial activity. Organizations undertaking economic development activities must:
- have a board of directors with broad community representation;
- have reasonable restrictions on the types of development activities that are appropriate;
- exit any investments in community businesses once the nonprofit organization breaks even;
- choose economic development activities based on community needs rather than profit motives;
- avoid involvement in day-to-day operations of businesses invested in.
- Joint Ventures. Form 1023 also requests information about joint ventures that the applicant will enter into in which the applicant will share profits and losses with a for-profit entity. The IRS permits 501(c)(3) tax-exempt organizations to enter into whole-entity joint ventures with for-profit entities so long as the exempt organization maintains control by owning at least 51% of the joint venture and the joint venture advances the exempt purpose. Alternatively, 501(c)(3) tax-exempt organizations are permitted to enter into ancillary joint ventures, in which only a part of the organization’s activities involves the joint venture. Any income unrelated to the organization’s exempt purpose is subject to the Unrelated Business Income Tax.
4.4.9 – Financial Data
Part IX of Form 1023 requires applicants to provide detailed financial data. Organizations that have existed for less than five (5) years must provide past or projected financial data for:
- Three (3) years if the organization has not completed one tax year; or
- Four years, including each of the years in which the organization has been in existence, if the organization has completed one tax year.
For organizations that have existed for at least five (5) years, the applicant must provide financial data for the last five (5) years.
For new organizations, Part IX of Form 1023 requires the applicant to break out the organization’s projected budget by line item in considerable detail. For this reason, it is important that new organizations planning to apply for 501(c)(3) tax-exempt status develop a projected budget early in the formation process.
4.4.10 – Public Charity Status
Part X of Form 1023 is designed to classify the applicant as a Public Charity or Private Foundation. Public Charities receive more favorable tax treatment than private foundations. Below are several ways that Public Charities are treated more favorably under the Internal Revenue Code than Private Foundations:
- Donations of Capital Gains Property. A donor who donate appreciated property, such as a stock account, to a public charity are permitted to deduct the fair market value of the property at the time of the donation from his or her income. A donor who donate appreciated property to a private foundation, however, may only deduct his or her basis in the property.
- Permitted Amount of Deduction. A donor is permitted to deduct donations to Public Charities up to fifty percent (50%) of his or her adjusted gross income. A donor is only permitted to deduct donations to Private Foundations up to twenty percent (20%) of his or her adjusted gross income.
- Long Term Capital Gains Property. A donor is permitted to deduct gifts of long-term capital gains property to Public Charities up to thirty percent (30%) of his or her adjusted gross income. A donor is only permitted to deduct gifts of long-term capital gains property to Private Foundations up to twenty percent (20%) of his or her adjusted gross income.
- Excise Tax on Passive Income. Private Foundations must pay a two percent (2%) excise tax on net investment income. Public Charities are not required to pay any excise tax on net investment income.
- Distribution Requirement. Private Foundations are required to distribute at least five percent (5%) of the organization’s investment income each year. Failure to comply with this distribution requirement subjects the organization to a significant excise tax. There is no comparable distribution requirement for Public Charities.
There are three tests the IRS uses to determine whether a 501(c)(3) tax-exempt organization is a Public Charity or a Private Foundation:
- Automatically Public Charities. Schools, hospitals, and churches are automatically classified as Public Charities.
- Donative Public Support Test. This test may be satisfied by a mathematical test or a totality of the circumstances test. Both consider the amount of total support for a nonprofit organization that is derived from public sources. To satisfy either test, a nonprofit organization should maximize donations from public grants and smaller individual donors, while minimizing donations from private foundations and large individual donors.
- Gross Receipts Public Support Test. The Gross Receipts Public Support Test considers both monetary donations and income generated from the organization’s activities. To meet the Gross Receipts Public Support Test, the organization should maximize donations from public grants and smaller individual donors, as well as revenue generated by activities related to the organization’s exempt purpose.