Understanding the Process for Obtaining Tax Exempt Status

Quick answer

• To get tax exempt status, your organization must apply to the IRS and meet specific requirements, usually related to its charitable, educational, religious, scientific, or other public-serving purpose.
• The most common type of tax exemption is under section 501(c)(3) of the Internal Revenue Code.
• You’ll need to file Form 1023 (or Form 1023-EZ for smaller organizations) with the IRS.
• The application process requires detailed information about your organization’s activities, finances, and governance.
• Maintaining tax-exempt status involves ongoing compliance with IRS regulations, including annual filings.
• It’s often advisable to consult with a legal or tax professional experienced in nonprofit law.

What to check first (before you file or change withholding)

Organizational Structure

Before applying for tax-exempt status, ensure your organization is properly formed as a legal entity. This typically means establishing it as a nonprofit corporation, trust, or association according to your state’s laws. This legal foundation is a prerequisite for federal tax exemption.

Purpose and Activities

Clearly define your organization’s purpose and the specific activities it will undertake. The IRS will scrutinize these to determine if they align with the requirements for tax-exempt status, such as benefiting a religious, charitable, scientific, educational, or other public purpose. Any private benefit or inurement (payment of profits to insiders) can jeopardize your application.

Financial Management

Develop a clear plan for how your organization will manage its finances. This includes establishing a budget, setting up accounting systems, and outlining how funds will be used to further your exempt purpose. The IRS requires detailed financial information as part of the application.

Governance and Operations

Establish a governing board and create bylaws or similar governing documents. These should outline how the organization will be managed, how decisions will be made, and how conflicts of interest will be handled. Sound governance practices are crucial for demonstrating that your organization is well-run and dedicated to its mission.

Step-by-step (how to get tax exempt status)

1. Determine Eligibility:

• What to do: Assess if your organization’s mission and intended activities fit one of the tax-exempt categories outlined by the IRS (e.g., 501(c)(3)).
• What “good” looks like: You have a clear understanding of which exemption category applies and can articulate how your organization’s purpose and activities meet its criteria.
• Common mistake: Assuming your organization automatically qualifies.
• How to avoid it: Thoroughly research the IRS guidelines for each exemption type and consult IRS Publication 557, “Tax-Exempt Status for Your Organization.”

2. Incorporate (if applicable):

• What to do: File articles of incorporation with your state government if you plan to operate as a nonprofit corporation.
• What “good” looks like: Your organization is legally recognized as a separate entity by your state.
• Common mistake: Skipping state incorporation, which is often a prerequisite for federal exemption.
• How to avoid it: Follow your state’s specific procedures for nonprofit incorporation.

3. Obtain an Employer Identification Number (EIN):

• What to do: Apply for an EIN from the IRS, even if you don’t plan to have employees. This is your organization’s federal tax ID number.
• What “good” looks like: You have received an official EIN from the IRS.
• Common mistake: Using a Social Security number instead of an EIN.
• How to avoid it: Apply online through the IRS website; it’s free and immediate.

4. Draft Bylaws and Governing Documents:

• What to do: Create organizational bylaws that outline the governance structure, board responsibilities, membership, and operational procedures.
• What “good” looks like: You have a comprehensive set of bylaws that clearly define your organization’s internal operations.
• Common mistake: Having vague or incomplete bylaws, which can lead to governance issues later.
• How to avoid it: Review sample bylaws from reputable nonprofit resource organizations and ensure they align with your state’s laws.

5. Develop Operational Plans and Policies:

• What to do: Outline your organization’s programs, activities, and how it will generate and use funds. Develop policies for financial management, conflict of interest, and record-keeping.
• What “good” looks like: You have a clear operational plan demonstrating how you will achieve your exempt purpose and manage resources responsibly.
• Common mistake: Failing to detail how activities will further the exempt purpose.
• How to avoid it: Be specific about your programs and how they contribute to your stated mission.

6. Choose the Correct IRS Form:

• What to do: Determine whether to file Form 1023 (Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code) or Form 1023-EZ (Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code).
• What “good” looks like: You have correctly identified the form that best suits your organization’s size and projected revenue.
• Common mistake: Filing the wrong form, which can lead to delays or rejection.
• How to avoid it: Review the eligibility requirements for Form 1023-EZ on the IRS website; if you don’t qualify, use Form 1023.

7. Complete and File the Application:

• What to do: Fill out the chosen IRS form accurately and completely. Attach all required supporting documents, including your articles of incorporation, bylaws, and financial data.
• What “good” looks like: Your application is thorough, well-organized, and includes all necessary attachments.
• Common mistake: Incomplete or inaccurate information, missing attachments.
• How to avoid it: Double-check all sections and ensure you have gathered all required documents before submitting.

8. Pay the Filing Fee:

• What to do: Submit the required user fee along with your application. The fee amount can vary.
• What “good” looks like: The correct fee is paid, and proof of payment is included with your application.
• Common mistake: Forgetting to include the filing fee or paying the incorrect amount.
• How to avoid it: Check the IRS website for the current user fee for your chosen form and follow their payment instructions.

9. Respond to IRS Inquiries:

• What to do: Be prepared to answer questions or provide additional information requested by the IRS during their review process.
• What “good” looks like: You respond promptly and comprehensively to any IRS requests.
• Common mistake: Ignoring IRS correspondence, which can lead to application denial.
• How to avoid it: Monitor your mail and email for IRS communications and address them promptly.

10. Receive Determination Letter:

• What to do: Once approved, the IRS will issue a determination letter officially recognizing your organization’s tax-exempt status.
• What “good” looks like: You have received a favorable determination letter confirming your 501(c)(3) status.
• Common mistake: Not understanding the effective date of exemption.
• How to avoid it: Note the effective date on the determination letter; it’s often retroactive to the date your application was received.

11. Maintain Compliance:

• What to do: File annual information returns (Form 990 series) with the IRS and comply with all state and federal reporting requirements.
• What “good” looks like: You consistently file accurate annual reports and adhere to all ongoing compliance obligations.
• Common mistake: Failing to file annual returns, which can lead to automatic revocation of tax-exempt status.
• How to avoid it: Set up a system for tracking filing deadlines and ensure timely submission of all required reports.

Common mistakes (and what happens if you ignore them)

Mistake	What it causes	Fix
<strong>Incomplete Application</strong>	Delays in processing, requests for more information, or outright denial.	Carefully review all application instructions and ensure all required fields are completed and all supporting documents are attached.
<strong>Incorrect Filing Status</strong>	Application may be rejected if the wrong exemption category is chosen.	Thoroughly research IRS publications to confirm the correct exemption category for your organization’s activities.
<strong>Using Form 1023-EZ Incorrectly</strong>	If your organization is ineligible for the EZ form, your application will be rejected.	Carefully review the eligibility criteria for Form 1023-EZ on the IRS website before choosing it.
<strong>Lack of Clear Mission Statement</strong>	Difficulty in demonstrating that activities align with exempt purposes.	Develop a clear, concise mission statement that directly reflects your organization’s charitable, educational, etc., goals.
<strong>Failure to Establish Bylaws</strong>	Poor governance, potential for internal disputes, and IRS scrutiny.	Draft and adopt comprehensive bylaws that outline the organization’s structure and operations.
<strong>Private Inurement or Benefit</strong>	Loss of tax-exempt status; potential penalties.	Ensure that no part of your organization’s net earnings benefits private individuals (insiders).
<strong>Not Obtaining an EIN</strong>	Inability to open bank accounts, file tax forms, or conduct other business.	Apply for an EIN from the IRS using Form SS-4 or online; it’s a necessary identifier for your organization.
<strong>Failure to File Annual Returns (Form 990)</strong>	Automatic revocation of tax-exempt status after three consecutive years of non-filing.	Establish a calendar reminder for annual filing deadlines and ensure timely submission of the appropriate Form 990 series return.
<strong>Operating Outside of Exempt Purpose</strong>	Can be seen as engaging in substantial non-exempt activities, jeopardizing status.	Ensure all activities are directly related to and further your organization’s stated tax-exempt purpose.
<strong>Not Maintaining Adequate Records</strong>	Difficulty in providing financial information to the IRS or demonstrating compliance.	Implement a robust record-keeping system for all financial transactions and program activities.

Decision rules (simple if/then)

• If your organization’s annual gross receipts are expected to be $50,000 or less and its total assets are expected to be $250,000 or less, then you may be eligible to use Form 1023-EZ.
• If your organization’s activities involve lobbying or political campaign intervention, then you likely cannot qualify for 501(c)(3) status, as these activities are generally prohibited.
• If you are unsure about your organization’s eligibility for tax exemption, then consult with a qualified tax professional or attorney specializing in nonprofit law because they can provide expert guidance.
• If your organization’s primary purpose is to provide a private benefit to individuals or a specific group, then it will not qualify for tax-exempt status because exemption is for public benefit.
• If you have already begun operations and incurred expenses before receiving your determination letter, then be aware that these expenses may not be deductible by donors until exemption is granted.
• If your organization has a history of non-compliance with reporting requirements, then it may face greater scrutiny from the IRS during the application process.
• If your organization plans to engage in any business activities that are unrelated to its exempt purpose, then it may be subject to unrelated business income tax (UBIT).
• If your state requires specific registrations for charitable solicitations, then you must comply with those requirements in addition to federal tax exemption.
• If your organization’s name is similar to an existing entity, then the IRS may question its distinctiveness and require clarification.
• If your organization’s bylaws do not adequately address conflict-of-interest situations, then the IRS may view this as a governance weakness.

FAQ

Q: What is the primary benefit of obtaining tax-exempt status?

A: The main benefit is that your organization is generally exempt from federal income tax on income related to its exempt purpose. Donors can also deduct contributions made to 501(c)(3) organizations, which can significantly boost fundraising.

Q: How long does it typically take to get tax-exempt status?

A: The processing time can vary significantly. For Form 1023-EZ, it might be a few months, while for the full Form 1023, it can take anywhere from several months to over a year, depending on IRS workload and the complexity of the application.

Q: Can my organization apply for tax exemption retroactively?

A: Yes, the IRS generally allows for retroactive exemption to the date your organization was formed or began operations, provided you file your application within a specified timeframe (usually 27 months from formation).

Q: What happens if my organization loses its tax-exempt status?

A: If tax-exempt status is revoked, your organization will be subject to federal income tax on its earnings. It can also be difficult to regain status and may require a new application and significant corrective actions.

Q: Do I need a lawyer to apply for tax exemption?

A: While not strictly required, it is highly recommended to consult with an attorney or tax professional experienced in nonprofit law. They can help ensure your application is complete, accurate, and addresses potential issues.

Q: What is the difference between Form 1023 and Form 1023-EZ?

A: Form 1023-EZ is a streamlined, shorter application for smaller organizations that meet specific criteria for gross receipts and assets. Form 1023 is a more comprehensive application for larger or more complex organizations.

Q: Are there state-level tax exemptions?

A: Yes, in addition to federal tax exemption from the IRS, most states have their own requirements and processes for granting state income tax exemptions, sales tax exemptions, and property tax exemptions. You will likely need to apply separately with your state.

What this page does NOT cover (and where to go next)

• State-specific tax exemption requirements: This article focuses on federal exemption. You’ll need to research and comply with your state’s laws for state income, sales, and property tax exemptions.
• Unrelated Business Income Tax (UBIT): This is a complex area of tax law that applies when tax-exempt organizations earn income from activities not substantially related to their exempt purpose.
• Specific legal requirements for different types of nonprofits: While 501(c)(3) is common, other types of tax-exempt organizations (e.g., 501(c)(4) social welfare organizations, 501(c)(6) trade associations) have different rules and application processes.
• Ongoing compliance and reporting for tax-exempt organizations: This includes detailed information on filing the Form 990 series and other required annual reports.
• Fundraising regulations and charitable solicitation laws: These vary by state and govern how organizations can solicit donations.