How Does Tax Exemption Work?

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Nonprofit agencies that offer beneficial services, such as religious, educational and charitable organizations, can qualify for tax-exempt status under Section 501(c) of the Internal Revenue Code. Tax exemption allows organizations to channel the revenues they generate through their fundraising efforts into their charitable work, rather than toward paying income taxes. However, organizations must meet specific qualifications and complete annual tax reports to obtain and maintain their tax-exempt status.

Qualifying Organizations

  • Charitable groups qualify for tax exemption under Internal Revenue Code Section 501(c)(3). These groups must be organized and operated exclusively for purposes that are charitable, religious, educational, scientific or literary, or that promote amateur athletics or create public safety awareness. Their causes can include serving the poor and underprivileged, eliminating prejudice and discrimination, and preventing cruelty to animals. Other groups that qualify under Section 501(c) include state-chartered credit unions, nonprofit health insurance issuers, and teachers' retirement fund associations. Groups that promote or lobby for political causes are not eligible for nonprofit status under Section 501(c).

Application Process

  • Groups filing for tax exemption under Section 501(c)(3) must complete IRS Form 1023 or Form 1023-EZ, the Application for Recognition of Exemption. The form includes questions on the group's contact information, organizational structure, specific activities and financial data, including any compensation to its board members and staff. The group must also attach an organizing document, which states that the group was formed specifically for a purpose listed in Section 501(c)(3) and, if the group dissolves, that its assets will be distributed to another 501(c)(3) organization or to a government agency.

Filing Tax Returns

  • Just because a group qualifies for tax-exempt status does not exempt it from filing tax returns. The organization must file a version of Form 990, a Return of Organization Exempt From Income Tax. Groups that bring in less than $50,000 in gross receipts can file a Form 990-N, also known as an "E-postcard." Organizations with gross receipts less than $200,000 or total assets less than $500,000 must file Form 990 or 990-EZ. Charities that have gross receipts over $200,000 or total assets over $500,000 must file Form 990. Private foundations must file Form 990-PF.

Staying Exempt

  • Tax-exempt groups must maintain their tax-exempt status with the IRS or risk paying severe penalties. If a nonprofit fails to file its version of Form 990 for three straight tax years, it will automatically lose its tax-exempt status on the filing due date of the third year. Also, if the IRS discovers that the group's organizers have received donations under false pretenses or submitted false information on their Form 990 returns, the group could lose its tax-exempt status.

References

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