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How to Form a Tax-Exempt Organization

February 21, 2023

There are two key components if you want to form a tax-exempt organization, also known as a nonprofit. The first is applying for tax-exempt status. The second is choosing the structure of your organization. Both of these require understanding federal tax law. Consulting a business attorney who has experience with tax-exempt organizations is recommended because IRS and state rules can be complicated. 

How Does an Organization Become Tax-Exempt?

An organization must apply for tax-exempt status through the IRS in the first instance. Tax-exempt status generally allows the organization’s net income to be exempt from income taxes. However, investment income and unrelated business income (i.e., income from a trade or business, regularly carried on, that is not substantially related to the purpose that is the basis of the organization’s exemption) is still taxable.

To become tax-exempt, an organization must take the following steps:

  • Incorporate. The organization must incorporate as a trust, corporation, or association.
  • Obtain an EIN. This can be done online or using IRS Form SS-4.
  • File Form 1023 with the IRS. On the form, you will need to provide a detailed business purpose statement that indicates your exempt purpose. [Note that smaller non-profits may be able to file Form 1023-EZ. However, this form can only be filed electronically.]
  • Provide documentation. You must submit:
    • Organization documents (e.g., Articles of Organization or Articles of Incorporation) with an explanation of the purpose of the nonprofit;
    • Operating documents (e.g., Operating Agreement, By-Laws, Trust Agreement); and
    • Financial information.

When Should You File for Tax-Exempt Status?

There is no deadline to file for tax-exempt status. However, if you file by the end of the 27th month after incorporation, the organization will be deemed tax-exempt from the date of incorporation. If you file after the end of the 27th month, the organization will be tax-exempt from the date of the application.

What Are the Different Types of Non-Profit Organizations?

There are several types of nonprofit organizations and you may select only one. These include the following:

  • Charitable Organization. Organizations organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, educational, or other specified purposes and that meet certain other requirements are tax-exempt under Internal Revenue Code Section 501(c)(3).
  • Private Foundation. Private foundations typically have a single major source of funding (usually gifts from one family or corporation rather than funding from many sources) and most have as their primary activity the making of grants to other charitable organizations and individuals, rather than the direct operation of charitable programs. They include both operating and non-operating foundations. Note that organizations that qualify under Section 501(c)(3) are classified as private foundations unless they fall under one of the exceptions listed in Section 509(a). 
  • Political Organization. A political organization subject to Section 527 is a party, committee, association, fund, or other organization (whether or not incorporated) organized and operated primarily for the purpose of directly or indirectly accepting contributions or making expenditures, or both, for an exempt function. Donations to organizations are not tax deductible for the donor.
  • Public Charity. The IRS requires that a public charity receive at least one-third of its contributions from the general public or can show that under all the facts and circumstances, it normally receives at least 10% of its support from governmental units or the general public.
  • Other Nonprofit. Organizations that meet specified requirements may qualify for exemption under subsections other than 501(c)(3). These include social welfare organizations, civic leagues, social clubs, labor organizations, and business leagues.

How Do You Choose the Best Type of Nonprofit Organization?

Each type of nonprofit organization has its own requirements, advantages, and disadvantages. The ideal one depends on your circumstances. Important considerations include the tax deductibility of donations, how funds can be used, and restrictions on how the organization is administered.

If you are considering starting a nonprofit, an attorney can advise you regarding what structure to use and how to set it up properly. Our attorneys work extensively with nonprofits and can assist you with launching and administering your organization. Contact our firm for a consultation.

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