As a small business owner or entrepreneur, you are more than likely aware that for-profit and non-profit organizations are held to different governmental tax regulations. In broad terms, a for-profit organization is responsible for paying taxes to federal, state and local governments. A non-profit organization is tax-exempt.
As a result, everyone would love to declare his or her business a non-profit, but there are very strict rules regulating that designation. We’ll examine these rules and the different types of non-profit entities below.
What Does 501(c)(3) Mean?
According to the IRS, in order for an organization to qualify for tax-exempt status under 501(c)(3), no private shareholder or individual should see a benefit from the organization’s earnings. In addition, it cannot actively campaign for political candidates, and must be formed and operated exclusively in a manner that addresses the purposes set forth in section 501(c)(3) (which are located on page 21 of the linked publication).
In most cases, these organizations are designated as charitable organizations. This means they can also receive tax-deductible contributions to fund their efforts.
Further 501(c)(3) Classifications
501(c)(3) classifies organizations into three distinct categories:
- Public Charity: This is the most common form of 501(c)(3). It is also what most people generally associate with the term “non-profit.” Public charities are eligible to receive tax-deductible donations from individuals (up to 50% of the donor’s income) and corporations (up to 10% of the organization’s revenue), and are governed by a board of directors. No more than 50% of the board can be related to each other. Governance of public charities is often scrutinized by the public, and even the implication of a misuse of funds can greatly undermine the charity’s mission. Public charities are expected to receive a substantial portion of their income from the public. Groups that fall into the public charity category include churches, animal welfare agencies, educational organizations and more.
- Private Foundation: A private foundation, which can also be referred to as a non-operating foundation, does not have active programs. Its revenue may come from a small group of donors or even an individual or family. Private foundations are sometimes established to grant money to other non-profit organizations or individuals working on the same exempt purpose of the foundation. A “family” foundation is a common type of private foundation. Donations to 501(c)(3)-recognized private foundations are still tax-deductible for individuals (up to 30% of the donor’s income).
- Private Operating Foundation: This is the least common type of 501(c)(3). Private operating foundations are similar to private foundations, but also have active programs like those found in a public charity. IRS regulations on private operating foundations are similar to those on private foundations. Many consider these foundations a hybrid between public charities and private foundations. Donations are still tax-deductible, just like a public charity.
Because private foundations and private operating foundations receive a larger proportion of their income from non-public sources, they are subject to much less public scrutiny than public charities.
Is There Anything 501(c)(3) Organizations Are Prohibited From Doing?
Yes; these organizations are highly regulated and monitored closely by the IRS for compliance. As stated above, the strictest regulations relate to the use of funds and political advocacy.
While 501(c)(3) organizations can lobby for specific legislation or to effect a vote, they are prohibited from donating directly to a politician’s campaign. This falls under the same rule as not allowing a private individual or shareholder to benefit from the organization’s earnings (e.g., donations).
Qualifying for—and maintaining non-profit status—is not easy, but it is possible. If you think your business might be eligible to become a 501(c)(3) organization, review the documents at IRS.gov and take the necessary steps.