Being Nonprofit Does Not Mean You Are Tax Exempt!
Do you know whether your organization in a non-profit? How about whether it is tax-exempt? Perhaps you did not realize that these two terms have entirely different meanings? In the world of charitable organizations, it is possible to be non-profit, tax-exempt, or both, depending on what steps the organization has taken to achieve these statuses. It can be crucial to understand the difference between the two terms to avoid confusion and possibly hefty penalties.
Non-profit, or not-for-profit, is a status conferred upon an organization by state law. In Illinois, for example, a new corporation may file Articles of Incorporation either as a business corporation or a not-for-profit corporation. Business corporations are capable of issuing stock to shareholders, operating a for-profit business enterprise, and disbursing profits to shareholders. Not-for-profit corporations, on the other hand, may not issue stock, must not disburse profits to its directors or officers, and must use income to promote a charitable, educational, or religious purpose.
The key difference between the two types of corporations is the mindset of the people involved. Not-for-profit organizations do not intend to keep their income for the benefit of the organization or its staff. While not-for-profit organizations may pay its employees and directors a reasonable salary, the purpose of the organization is to collect money to benefit a charitable, educational, or religious purpose. This is the opposite of a business corporation, which benefits itself and its shareholders.
There are a few different types of tax exemptions, but the most important is an income tax exemption. This is almost always what is meant when referring to a tax-exempt organization. An income tax exemption means that the organization has applied to the IRS for the exemption and the IRS has approved the application. Only then may the organization call itself tax-exempt. You are not income tax exempt unless the IRS says you are tax exempt.
With a few exceptions, a tax-exempt organization is not required to pay income tax on the money it collects throughout the year. Instead, the tax-exempt organization files a Form 990 with the IRS which describes the organization’s activities, income and expenses throughout the year. So long as the IRS does not find any activity or income which violates the rules for tax-exempt organizations, the organization’s tax exemption remains active and no tax is owed. There is a similar process for state income taxes, as well as a similar form that must be filed every year to report activities and income.
However, even if an organization is exempt from income taxes, the organization may be subject to other types of taxes, such as sales tax, real estate tax, and taxes on any unrelated business. You must file separate applications to different state agencies to receive exemptions from sales tax and real estate tax. Thus, it is entirely possible to be exempt from one type of tax and not another, depending on which applications your organization has submitted.
Non-Profit vs. Tax-Exempt
A charitable organization will likely need to be both non-profit and tax-exempt. The non-profit status ensures that the organization is obeying state law by not earning profits for itself or its employees. The tax-exempt status ensures that the IRS has approved the charitable purpose of the organization and that no income tax is owed. Since the state and the IRS are two separate governmental entities, it is important to realize that the approval of one of them has no impact on the other.
It is thus entirely possible to be a non-profit organization that still owes income tax. The solution to this problem is to apply to the IRS for a tax exemption. Otherwise, you may think that your organization does not need to file a tax return each year. There are severe penalties from the IRS if you have not received a tax exemption and you fail to file a tax return each year.
It is also possible to be a tax-exempt organization that is not organized as a non-profit under state law. The solution to this problem is to change the type of organization at the state level. Each state has different rules regarding the types of organizations that you can create. The IRS does not worry itself with all these differences and instead creates its own classifications based on the general type of organization, such as corporation, LLC, unincorporated organization, and partnership. The IRS may grant a tax exemption to any of these types of organizations, even though the state that created the organization does not label the organization as non-profit. In these cases, the mindset of the organization’s directors determines whether the organization is non-profit.
If you are not sure whether your organization is non-profit, tax-exempt, or both, please contact our office to discuss. We can guide your organization to hopefully becoming both.