Nonprofit Organizations, and Taxes

In recognition of the "public good"-oriented goals and objectives of nonprofit organizations, U.S. law grants these groups a number of special privileges. Of these, perhaps none is more valuable than the bestowal of tax-exempt status. Such status basically means that the organization's income and assets are not subject to federal taxes, and federal exemptions often (though not always) pave the way for state and local tax exemptions as well. For-profit enterprises, on the other hand, are subject to local, state, and federal taxation.

One of the main objectives of private enterprise is the pursuit of profit for the owners of the enterprise. Profits gained through private enterprise are taxable. Activities undertaken by tax-exempt organizations have as their objective obtaining profits for use in the continued provision of services for the public good. Profits earned by organizations as a result of their tax-exempt missions are not taxable. Nonprofit organizations can engage in virtually any business enterprise in the fulfillment of their mission objectives without jeopardizing their tax-exempt status. When these organizations undertake activities that are unrelated to their stated missions, than the profits generated from those activities are taxable. It should be noted, however, that complete exemption from federal taxation does not automatically mean that the organization avoids other kinds of taxation, such as state and/or local income taxes, sales taxes, and property taxes.

Bruce R. Hopkins noted in his Legal Guide to Starting and Managing a Nonprofit Organization that not all nonprofit organizations qualify as tax-exempt organizations: "Nearly every tax-exempt organization is a non-profit organization, but not all nonprofit organizations are eligible to be tax-exempt," he said. "The concept of a nonprofit organization is broader than that of a tax-exempt organization. Some types of non-profit organizations (such as mutual, self-help type entities) do not, as a matter of federal law, qualify for tax-exempt status." While the majority of nonprofit organizations are presumed to be tax-exempt in nature, there are exceptions to that premise. The terms nonprofit and charitable are not interchangeable. A nonprofit organization is not necessarily charitably motivated while an organization that is truly charitable in nature may well be a profit-making enterprise. Both types of organizations may be entitled to tax-exempt status from the IRS. For example, a religious and apostolic association, even if it is organized for profit, and a teacher's retirement fund association, which is operated to produce profits for its beneficiaries, are both eligible for tax exemptions.

DEVELOPMENT OF NONPROFIT TAX-EXEMPT STATUS

Until the end of the 19th century, all U.S. entities—whether they were private individuals or businesses—were exempt from taxation unless they were subject to a particular tax levy. The Tariff Act of 1894, however, changed that situation irrevocably. That legislation imposed a flat 2 percent tax rate on all U.S. corporations, but in recognition of the fundamentally different goals and objectives of for-profit businesses and charitable and educational groups, the bill exempted the latter organizations from the tax. The important aspect of this legislation is that organizations involved in activities and those whose profits would be used for altruistic purposes were specifically excluded from the requirement to share the profits of their work through taxation. The initial emphasis of tax exemption was to protect those organizations involved in charitable activities from taxation, and it has remained as the central function of tax-exempt law to this day.

In recent years, the United States has seen a dramatic increase in the number of tax-exempt organizations operating around the country. Indeed, the rise in the number of churches, nursing homes, hospitals, chambers of commerce, charitable organizations, and social service agencies in many communities has led some observers to voice concern about the tax-base stability of some areas. Some cities and towns find that a substantial portion of their entire lot of privately held real estate is owned by tax-exempt organizations. In such areas there may not be any revenue flowing into local tax coffers from a taxable base. This state of affairs has led some corporate and individual taxpayers to register complaints about the "free ride" that some exempt organizations enjoy. Even the tax-exempt status of churches, protected from the very beginning of the tax code, has been questioned in recent years.

NONPROFITS AND PROFITABILITY

Many people operate under a fundamental misconception about nonprofit organizations and revenue. The word 'nonprofit' may carry with it an inference about profit that causes some people to think profitability by a nonprofit organization is illegal. This is not at all the case. Nonprofit, tax-exempt organizations are free to do anything a for-profit company might do in pursuit of their goals, including making profits. The law is designed to provide all the benefits of a free-market system plus the special favor of tax incentives for individuals and corporations who want to contribute financially to our efforts. Not only may nonprofit organizations operate enterprises profitably as tax-exempt organizations, they may also prosper through the patronage of others.

But there are significant stipulations in place concerning the distribution of those profits that must be met for an organization to claim tax-exempt status. These are delineated in Section 501 of the Internal Revenue Code:

1. The organization must be organized and operated exclusively for one or more of the following purposes: for religious, educational, charitable, scientific, or literary purposes; to test for public safety; to encourage amateur sports competition (either national or international); to prevent cruelty to children or animals; to lessen the burdens of government (through creation and/or maintenance of public buildings, monuments, parks, natural attractions, etc.); and to maintain public confidence in the legal system. Naturally, the organization may be involved in more than one of the above areas.
2. Net earnings garnered by the organization may not, under any circumstances, be distributed for the private benefit of individuals.
3. The organization may not participate in any way in any political campaigns, directly or indirectly (although it can use a political action committee or PAC to engage in political activities that are not political campaign activities).
4. The organization may not spend "excessive" time or energy on efforts to influence legislation. It is a common misconception that nonprofits may not engage in legislative activities, but as Hopkins stated, "a charity is permitted to engage in far more lobbying efforts than most people realize. Indeed, under some circumstances, a charitable organization can spend more than one-fifth of its funds for legislative ends."

FILING FOR TAX-EXEMPT STATUS

A wide variety of organizations are eligible for tax-exempt status because of their goals and activities. These include the following:

• Corporations organized under an Act of Congress (includes federal credit unions)
• Title-holding corporations for exempt organizations
• Religious organizations
• Educational organizations
• Charitable organizations
• Scientific organizations
• Literary organizations
• Public safety organizations
• Organizations devoted to national or international amateur sports competitions
• Organizations devoted to preventing cruelty to children
• Organizations devoted to preventing cruelty to animals
• Civic leagues
• Social welfare organizations
• Local associations
• Labor organizations
• Agricultural and horticultural organizations
• Business leagues, chambers of commerce, and real estate boards
• Social and recreational clubs
• Fraternal beneficiary societies and associations
• Voluntary employees' beneficiary associations
• Domestic fraternal societies and associations
• Teachers' retirement fund associations
• Benevolent life insurance associations
• Mutual irrigation or ditch companies
• Mutual or cooperative telephone companies
• Cemetery companies
• State-chartered credit unions and mutual reserve funds
• Mutual insurance companies or associations
• Cooperative agricultural organizations
• Supplemental unemployment benefit trusts
• Employee funded pension trusts (provided they were created prior to June 25, 1959)
• Organizations of past or present Armed Forces members
• Group legal services organizations
• Black lung benefit trusts
• Withdrawal liability payment funds
• Veteran's organizations (provided they were created prior to 1880)
• Religious and apostolic associations
• Cooperative hospital service organizations
• Cooperating service groups of operating educational organizations
• Farmer's cooperatives
• Political organizations (parties, committees, etc.)
• Homeowners' associations

Some organizations such as churches, associations of churches, and auxiliary agencies of churches—like mission societies and youth groups—are generally considered automatically tax-exempt. They are not required to request this status from the government taxing agencies. Virtually all other kinds of organizations that fit legal definitions of eligibility for tax-exempt status because of their special benevolent purposes and goals cannot make the same assumption. They must ask the Internal Revenue Service to officially recognize their tax-exempt status."

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