Section 501(c)(3) is the section of the Internal Revenue Code (IRC) that describes educational, literary, religious, scientific and other charitable organizations that are exempt from federal income taxes (not required by law to pay federal taxes on any income generated by the organization). Nonprofit organizations that want to be recognized as exempt from federal income taxes must submit Form 1023 to the Internal Revenue Service (IRS) to apply for tax-exempt status under section 501(c)(3).
There are two classifications under section 501(c)(3) that are eligible to receive federal tax benefits: (1) private foundations, and (2) public charities. Broadly defined, private foundations receive contributions from a few donors, while public charities rely on many donors for support. Three main distinctions between the two make a public charity classification more favorable: (a) private foundations are subject to more extensive reporting requirements than public charities; (b) the tax deductions for contributions made to private foundations are more restricted than the contributions made to public charities; and (c) public charities are not subject to the same excise taxes that are imposed on private foundations.
Initially, every organization that qualifies for tax exemption under section 501(c)(3) is presumed by the IRS to be a private foundation. In order to be considered a public charity, you have to show the IRS that your organization falls under one of the following “exceptions” referred to in section 509(a) of the IRC (see Table 1 below):
This article is intended for individuals applying for a 501(c)(3) tax exempt status under section 509(a)(1) within the meaning of 170(b)(1)(A)(vi), or under section 509(a)(2) (both italicized and bolded in Table 1). For simplicity and distinction, I’ll refer to section 170(b)(1)(A)(vi) as a “donation-based” publicly supported charity, and section 509(a)(2) as an “earning-based” publicly supported charity. In general, “donation-based” charities receive most of their support from individual contributions, grants, government, or other public sources; and “earning-based” charities receive a substantial amount of their income from membership dues or activities related to their tax-exempt function. Donation-based and earning-based charities are the broadest forms of a nonprofit organization, and they are the most commonly sought out classifications when applying for federal tax exemption.
To qualify for tax-exemption as an “earning-based” or a “donation-based” publicly supported charity, your nonprofit must pass the organizational and public support tests:
501(c)(3) ORGANIZATIONAL TEST
For starters, in order to qualify for federal tax exemption under any section of the IRC, your nonprofit must be organized as a corporation (including a limited liability company), an unincorporated association, or a trust, and it must pass the “organizational test”. The organizational test requires that your nonprofit’s organizing document contains an exempt purpose clause and a dissolution clause:
An exempt purpose clause is the language used in your organization’s articles of incorporation that (1) limits its purposes to those described in section 501(c)(3): charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals (our focus is charitable); and (2) does not authorize your nonprofit to engage (other than as an insubstantial part of its activities) in activities that do not further one or more of these tax-exempt purposes.
A dissolution clause provides a statement that your nonprofit’s assets will be distributed for exempt purposes should the organization dissolve. In some states you can rely on state law to establish provisions for asset dissolution; however, including a dissolution clause in your articles will expedite the application process.
501(c)(3) PUBLIC SUPPORT TEST
In addition to the organizational test, the revenue received by your nonprofit must undergo certain public support tests to qualify for tax exemption as an “earning-based” or a “donation-based” public charity.
Donation-Based Charities can qualify by meeting one of the two following public support tests:
(1) One-third support test – Under this test, your nonprofit must normally (over a 5-year period) receive 1/3rd of its total support from governmental units and/or contributions made directly or indirectly by the general public. If your nonprofit’s support meets the 1/3rd requirement, then it qualifies as a publicly supported charity and no further tests are necessary.
(2) Facts and circumstances test – This test gives your nonprofit a second chance to qualify if it fails to meet the 1/3rd support test. To be eligible, your organization must meet all of the following three requirements:
A. Ten-percent-of-support requirement – Under this requirement, at least 10% of your nonprofit’s total support must normally (over a 5-year period) be supplied by governmental units and/or contributions made directly or indirectly by the general public.
B. Attraction of public support requirement – Under this requirement, your organization’s fundraising plan must demonstrate its intent to attract new and additional funds from the general public/community, governmental units, or other charitable organizations described in section 509(a)(1).
C. Additional requirements – In addition to “A” and ‘B”, the IRS also considers the following five public support factors in determining whether your organization is publicly supported (your nonprofit only needs to satisfy a sufficient combination of the factors):
a) Percentage of financial support factor – Takes into account that the more your organization’s public support exceeds 10%, then the lesser the burden of proving its public-support nature through factors “b” through “e”;
b) Sources of support factor – Considers the fact that your organization receives support from various government/public sources rather than from members of a single family;
c) Representative governing body factor – Considers that fact that your organization has a governing body that represents the broad interest of the public rather than the personal interest of a few people;
d) Availability of public facilities or services factor – Considers that fact that your organization provides facilities or services that benefit the general public; and
e) Additional factors pertinent to membership organizations – Considers that fact that (1) member solicitations are designed to enroll a substantial number of dues-paying members; (2) membership dues are kept at an affordable rate that allows access to a broad range of interested individuals; and (3) organizational activities are designed to appeal to individuals with broad common interests.
Earning-Based Charities can qualify by meeting both of the following public support tests:
(1) One-third support test – Under this test, your nonprofit must normally (over a 5-year period) receive more than 1/3rd of its total support from a combination of gifts, grants, contributions, membership fees; and gross receipts from admissions, merchandise sales, services performed, or facilities supplied for activities related to your nonprofit’s exempt function. Support must be received from permitted sources which includes: section 509(a)(1) organizations, governmental agencies, and individuals who are not substantial contributors, managers, or entities related to them.
(2) Not-more-than-one-third support test – This test restricts your organization from normally (over a 5-year period) receiving more than 1/3rd of its support, in each tax year, from the sum of: gross investment income & the excess of taxable income from unrelated trades or business acquired after June 30 June 30, 1975, over the tax imposed on that income.
If you have a start-up organization, it will be classified as an “earning-based” or a “donation-based” charity based on the information you provide in Form 1023 (financial projections, current/proposed program activities, organizational structure, and actual/intended method of operation). If the information provided demonstrates that your nonprofit can reasonably be expected to meet one of the public support tests during its first 5 tax years, then your nonprofit will receive a public charity classification for its first 5 years of operation. However, if your organization has been in existence for 5 years or more, you’ll need to report financial information for the current tax year and the 4 tax years immediately before the current tax year (a total of 5 years) on your application for exemption. If the information provided meets the public support tests, your organization will be classified as a public charity for the current and the following tax year.
“DO IT YOURSELF”
If you would like a step-by-step “do it yourself” guide to obtaining your organization’s 501 (c)(3) federal tax exemption, visit jdaccountingsolutions.com. Utilizing my personal experience, this guide simplifies the process of applying for federal tax exemption into 12-steps. This guide provides you with tips, explanations and insight as you’re guided line by line through the tax exemption application. Also included is a unique “Sneak-A-Peek Edition” that allows you to peek at the documents I submitted to the IRS when applying for my own nonprofit’s tax exempt status. Plus, as an added bonus you’ll receive links to several free resources to assist you in growing your organization.