Frequently Asked Questions
1. Is a nonprofit corporation automatically tax-exempt under Section 501(c)(3)?
No. Nonprofit status is a creature of state law and it does not automatically result in federal or state income tax exemption under Section 501(c)(3). An entity that organizes as a nonprofit corporation is generally subject to federal and state income tax unless it files IRS Form 1023, Application for Recognition of Exempt Status under Section 501(c)(3) of the Internal Revenue Code (“IRS Form 1023”), and satisfies the requirements under Section 501(c)(3). There are numerous nonprofit corporations that do not file Form 1023 and are therefore subject to income tax.
2. What is the legal process to secure tax-exempt status under Section 501(c)(3)?
The following is an overview of the steps and standard documents necessary to secure tax-exempt status under Section 501(c)(3). Additional steps or documents may be necessary.
Step 1. Organize under state law (e.g., as a nonprofit corporation or charitable trust).
Step 2. For nonprofit corporations, complete the organizational process by conducting an organizational meeting (or executing a written consent) to adopt Bylaws and a Conflict of Interest Policy, and appoint and empower officers.
Step 3. File IRS Form SS-4, Employer Identification Number.
Step 4. File IRS Form 1023.
Step 5. Respond to IRS questions, if any.
Step 6. If approved, the IRS will provide a Determination Letter recognizing the organization as tax-exempt under Section 501(c)(3).
3. Do I need a professional advisor to secure tax-exempt status under Section 501(c)(3)?
No. A professional advisor is not legally required to secure tax-exempt status. However, in our experience, it is important to secure an experienced professional advisor to assist with the organizational process and preparation of the necessary state and federal documents. For example, although many states and third parties provide sample Articles of Incorporation, often these form documents do not satisfy the Section 501(c)(3) organizational requirements and will not be accepted by the IRS. In addition, the IRS Form 1023 includes “terms of art” that may have special meanings that are not readily apparent or that are different from their common every-day meanings. In certain cases, an organization’s activities may need to be amended to address an area of concern. An experienced professional advisor will guide an organization through the maze of definitions and special rules, and identify and help address areas of special concern, to make the entire process as painless and seamless as possible.
It is worth noting that we have been involved with matters where an organization filed the IRS Form 1023 without professional advice, and failed to address an area of concern, or mistakenly responded unfavorably to a particular question. These organizations received substantial push back from the IRS, including tentative conclusions that the organization is not qualified under Section 501(c)(3). The time (and legal fees) to amend the IRS Form 1023 under these circumstances is typically twice what would have otherwise been required if an experienced professional advisor prepared and submitted the IRS Form 1023 on behalf of the organization.
4. What are the costs and estimated legal fees to establish a nonprofit corporation and file for tax-exempt status under Section 501(c)(3)?
The cost to establish a nonprofit corporation varies by state but is typically less than $150. For example, the filing fee to incorporate in Missouri is $25, Delaware is $139 (plus $9 per additional page), Illinois is $50, New York is $75, Georgia is $140, and California is $30. The IRS Form 1023 filing fee is generally $850, unless the organization estimates that its gross revenues will average less than $10,000 for its first four years of existence, in which case the filing fee is $400.
Legal fees will vary depending on the nature and complexity of the organization’s legal structure and activities. In our experience, for example, the legal fees to organize a basic nonprofit corporation under state law and prepare and submit IRS Form 1023 for an organization with one (1) activity and a straightforward exempt purpose are typically between $5,000 and $7,500. To the extent the organization desires a complex legal structure (such as a membership structure or special voting provisions), has numerous activities, or is engaged in activities that do not fit firmly within established IRS precedents, the legal fees may exceed this range. In addition, to the extent the organization conducts activities that receive special IRS review or scrutiny or the organization will engage in complex relationships with for-profit or nonprofit organizations, the legal fees will likely be greater. Finally, and perhaps most importantly, this fee estimate does not include other legal issues that may arise in connection with the formation of a nonprofit corporation, including (but not limited to) real estate, employment, contract, finance, intellectual property, joint venture, and other registration issues, as well as other tax issues that may arise in connection with the operation of the organization.
5. How long does it take to obtain Section 501(c)(3) status?
After the IRS Form 1023 is filed, the IRS has 270 days within which to respond to the applicant. In our experience, organizations with simple corporate structures, with few activities that are firmly within IRS precedents, and which do not raise any red flags, can be approved within 6-8 weeks of filing the IRS Form 1023 without any further questions. We estimate that less than 20% of the IRS Form 1023s are approved in this manner. For the majority of IRS Form 1023s, the organization should expect to receive follow-up questions from the IRS typically within 4-6 months of filing the Form 1023. After the organization responds to such questions, it usually takes another 3-5 weeks for the IRS to respond, typically with a favorable determination letter recognizing the organization as exempt under Section 501(c)(3) (assuming the organization adequately responded to all questions and addressed any concerns). On occasion, the IRS will ask additional questions.
6. Is a Section 501(c)(3) organization exempt from state sales and property tax?
No. State sales tax and property tax exemption is governed under state law. In general, an organization exempt under Section 501(c)(3) will not automatically be exempt from sales or property tax. Instead, a separate application is required to secure sales tax exemption (generally filed with the state department of revenue or tax board) or property tax exemption (generally filed with the county assessor or taxing authority). It is important to also note that most states expressly provide that exemption under Section 501(c)(3) will have no bearing on whether the organization is entitled to sales or property tax exemption.
7. What are the on-going filing requirements for a Section 501(c)(3) organization?
An organization’s filing obligations will vary depending on its activities. However, we would like to highlight four common filing obligations. First, a Section 501(c)(3) organization must file IRS Form 990, IRS Form 990-EZ, or IRS Form 990-N, depending on its revenues and assets, by the 15th day of the 5th month following the end of its fiscal year (e.g., May 15 for calendar year charities). Second, nonprofit corporations generally must file an annual report with the appropriate Secretary of State each year. Third, most states require annual (or periodic) reporting regarding charitable solicitation activities within the state (such reporting is typically made to the state Attorney General office). Fourth, to the extent an organization has compensated employees, it will likely be subject to federal and state withholding and reporting obligations. Other reporting requirements will likely apply.