Nonprofit vs. Tax-Exempt – Examining the Differences
by Peter Smith
A lot of clients and prospective clients come into meet with us here at Apex Law, and express some confusion over the difference between being a not for profit corporation, and a tax-exempt organization. There is a perception out there that the two concepts are one in the same, when in fact they are much different.
If you are considering starting a social enterprise and thinking about the costs and benefits of being not for profit, here are a few of the questions that we often face, along with the answers, which should help you evaluate whether or not you want to incorporate as a nonprofit corporation.
What is a Nonprofit Corporation?
In Washington State, the Nonprofit Corporation Act is RCW 24.03, and defines nonprofit as meaning, “a corporation no part of the income of which is distributable to its members, directors or officers.” RCW 24.03.005(3). Put simply, this means that you cannot distribute the proceeds of your nonprofit to the members and directors. If, at the end of the year, your nonprofit is cash flow positive and you have $100,000 in the bank after you’ve paid all costs associated with running the business, you cannot take that $100,000 and split it up amongst the directors as a dividend. You have to reinvest it into the company, or perhaps donate it to a charity of some kind.
If a Nonprofit Corporation cannot distribute income to members, directors, or officers, does that mean that everyone involved has to be a volunteer?
No. A nonprofit corporation has to run like any other business does and that includes the costs of operating the business itself. Costs such as salary, benefits, goods associated with running the company, and other costs that all businesses face, are allowed to be paid by nonprofit corporations. RCW 24.03.035 – General Powers – allows for nonprofit corporations to “elect or appoint officers and agents of the corporation, and define their duties and fix their compensation. “ RCW 24.03.035(11).
Thus, the restrictions placed on a nonprofit in terms of distributing income to its members, directors, or officers, does not mean that a nonprofit cannot pay its employees for the work they are performing.
What about Taxes? Does a Nonprofit Corporation under RCW 24.03 have to pay taxes?
Yes. There is a very key distinction between being “not for profit” and being “Tax-Exempt.” Being “not for profit” or a “nonprofit” means that your company is organized under the Nonprofit Corporation Act, RCW 24.03. Your company will be subject to the guidelines and boundaries contained within RCW 24.03. What it does not mean, is that you are exempt from paying taxes. Becoming “Tax-Exempt” is a status that a nonprofit corporation seeks with the IRS. It is a federal distinction, separate and apart from the state code, or RCW.
What does it mean to be Tax-Exempt?
Becoming a tax-exempt organization requires filing documents with the Internal Revenue Service, allowing them to review your organization, and then obtaining a determination whether or not your organization qualifies to be tax-exempt. Generally, most charities and nonprofits seek tax exemption under section 501(c )(3) of the internal Revenue Code. Section 501(c )(3) sets forth the requirements to being a “charitable organization” as defined by the IRS. There are alternate forms of exemption (such as 501(c )(4) for example, for political organizations), but by in large, most nonprofit corporations seeking tax exempt status will be doing so under the “Charitable Organizations” exemption.
The requirements for being tax-exempt under section 501(c )(3) are that your corporation be operated “exclusively for exempt purposes.” Exempt purposes include, “charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.” (see this link to IRS page for more information).
How do I become a Tax Exempt organization?
Hire a lawyer! Ha. You knew I was going to say that didn’t you.
Well, in this instance, that advice is probably pretty sound. Becoming a 501(c )(3) tax-exempt organization requires filling out and filing Form 1023 with IRS, which is a lengthy an voluminous document that must be treated with care. Every form 1023 that is filed is subjected to considerable scrutiny and if the IRS has questions about the information provided in your Form 1023, they may come back to you with a request for more information, or in other cases, reject your application. Each Form 1023 costs $400 if your organization’s gross receipts are less than $10,000 over a 4 year period, and $850 if gross receipts are over that amount during that time.
Hiring a lawyer, or consulting with someone who has experience with Form 1023 applications, can save you a lot of stress and help your nonprofit maximize the chances that it will be approved for Tax-Exempt status.
How Long until you can be Tax-Exempt?
Unfortunately, a long time. The IRS takes several months to review most Form 1023 applications (although you’ll be amazed how fast the check you send in with the application is cashed) so you should budget the better part of year if you decide to move forward with seeking tax-exempt status.
If we become tax-exempt, then what?
Well, to be frank, you better be prepared to learn to live with the significant oversight and regulation that comes with tax-exempt status. Restrictions on salaries paid, how you take money in, how you spend your money, everything. Being tax-exempt is a big responsibility and it’s something that needs to be taken seriously. The IRS has no patience for 501(c )(3) organizations that abuse their tax-exempt status in any manner.
The bottom line is that being a nonprofit corporation and a tax-exempt entity are horses of a different color. Many nonprofit corporations (such as homeowner’s associations) never achieve (or try to achieve) tax-exempt status. For those that do, however, it’s a serious undertaking at the federal level, that requires organization and education regarding the regulations that you will be subjected to. Consult with a lawyer before making any decisions, and find one whom you are comfortable working with over the long haul.
July 7, 2020