Starting a Nonprofit Organization: Federal Tax-Exempt Status

Once a non-profit organization has been incorporated with the state, obtained a federal employee identification number, formed a board, and commenced operations, it can apply for tax-exempt status with the federal government.

There are two major reasons why a nonprofit may desire tax-exempt status. First, exempt status allows a nonprofit to avoid paying federal corporate taxes. By virtue of acting within charitable purposes as defined by the IRS, the nonprofit is granted the privilege of avoiding business taxes. Of course, the nonprofit must verify that its activities remain consistent with its non-profit purposes in order to remain exempt from these taxes. Second, exempt status allows those who donate to the nonprofit to claim a tax deduction in certain situations. The nonprofit will likely be able to increase its potential donation base by assuring donors that their gifts are, in fact, tax-deductible. In some circumstances, donors will want to see a copy of the letter from the IRS verifying the tax-exempt status of the nonprofit.

In order to apply for tax-exempt status, nonprofits must complete and submit Form 1023 (or in some circumstances, the streamlined Form 1023-EZ). This form must be submitted electronically by creating an account at pay.gov. Form 1023 is a lengthy and complex form that requires detailed information about the nonprofit’s programs, financial projections, compensation practices, and board governance. A legal or tax professional should be consulted to assist in completing the application.

The IRS currently requires a $600 filing fee. Though the professional costs and filing fee may cause some nonprofits reluctance, the financial benefits described above often outweigh the costs associated with preparing and filing the application form. The application usually takes about five months to be reviewed and approved by the IRS, though the time can be shorter or longer. Because of the lengthy processing time, a nonprofit should plan ahead to file the application long before it anticipates needing the approval letter.

The tax-exempt recognition letter from the IRS may also be useful for the organization when applying to avoid other kinds of taxes including sales tax on purchases, and property tax on real estate. The letter may be requested before estate gifts or stock donations are transferred, as well.

Most nonprofits are required to file an annual information return, Form 990. Although federal corporate taxes will not be owed if the organization operates consistently with its approved nonprofit purposes, the entity will be required to make this annual disclosure of information similar to what was provided in the original Form 1023 application. All the information disclosed in the annual information return will be open to the public. Accordingly, a tax professional should also be consulted in preparing the nonprofit’s annual information return. It may be most efficient to use the same professional to apply for exempt status and to make the annual information return filings. It should be noted that churches are not required to file the annual 990 return.

Contact Clergy Financial Resources to help you with the next steps.

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Clergy Financial Resources serves as a resource for clients to help analyze the complexity of clergy tax law, church payroll & HR issues. Our professionals are committed to helping clients stay informed about tax news, developments and trends in various specialty areas.

This article is intended to provide readers with guidance in tax matters. The article does not constitute, and should not be treated as professional advice regarding the use of any particular tax technique. Every effort has been made to assure the accuracy of the information. Clergy Financial Resources and the author do not assume responsibility for any individual’s reliance upon the information provided in the article. Readers should independently verify all information before applying it to a particular fact situation, and should independently determine the impact of any particular tax planning technique. If you are seeking legal advice, you are encouraged to consult an attorney.

For more information or if you need additional assistance, please use the contact information below.

Clergy Financial Resources
11214 86th Avenue N.
Maple Grove, MN 55369

Tel: (888) 421-0101 
Fax: (888) 876-5101
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