Nonprofit Law Basics: Nonprofit Corporation vs. 501(c)(3) Tax-Exempt Organization

Jan 7, 2012 by Mollie Cullinane

The word “nonprofit” generally is used to describe organizations that work to serve a public purpose, rather than to provide financial benefit to any particular individual, corporation, or entity. Most nonprofits are organized around a particular mission or community goal; such groups often work to address an unmet community need.

There are many terms used to describe these nonprofit organizations. Some people may mistakenly call a nonprofit organization a “501(c)(3)” or “tax-exempt group.” Actually, many nonprofits are generally organized and operated as both nonprofit corporations and tax-exempt entities.

• Nonprofit status refers to incorporation status under state law.

• Tax-exempt status refers to federal income tax exemption under the Internal Revenue Code (the “Code”).

What is a Nonprofit Corporation?

Nonprofit corporate status is state law concept. Your state’s Secretary of State’s website should provide information on what types of business entities nonprofits can operate as and how to set up such entities.

Nonprofit organizations can take several different business forms. Many nonprofits decide to incorporate as a nonprofit corporation; others decide to operate as an unincorporated nonprofit association. Some states also allow charitable trusts and certain limited liability companies to operate as nonprofits. However, the most common form is the nonprofit corporation.

A “nonprofit corporation” is a corporation in which no part of the income is distributable to members, directors, or officers.

In Texas, a nonprofit corporation is created by filing a certificate of formation with the Secretary of State.  It may be created for any lawful purpose, which will be stated in its certficate of formation. The certificate of formation is similar to a corporation’s birth certificate, in that it shows when it came into existence.

Some states call this organizing document the “articles of incorporation.”

Why Incorporate as a Nonprofit Corporation?

• Permanence of organization;
• Liability protection for individual leaders of the organization in some circumstances;
• Separate entity — the organization is a legal entity separate from the individuals who founded it or who manage it;
• Reduced postal rates; and
• Potential tax benefits (federal, state, local) if the corporation seeks tax-exemption; among others.

Learn about setting up a nonprofit corporation here. 

What is a Tax-Exempt Entity?

Tax-exempt status exempts a nonprofit from paying corporate federal income tax on income generated from activities that are substantially related to the purposes for which the group was organized.

Many people call such organizations “501(c)’s” or “501(c)(3)’s”. This refers to tax-exempt status.

Tax-exempt status offers many benefits, including:

• Exempt from paying corporate income tax on income generated from activities that are substantially related to the charitable purposes;
• Individuals and certain organizations can make tax-deductible contributions to the nonprofit organization;
• Groups may save money on state taxes when purchasing goods and services for use by the organization; and more.

Not Exempt for All Taxes, Though.

Tax-exemption does not mean that a nonprofit corporation is exempt from all taxes.

Most tax-exempt entities are still subject to a wide variety of other taxes, including federal payroll (Social Security, Medicare, and unemployment) taxes, unemployment taxes, real estate taxes, personal property taxes, sales and use taxes, franchise taxes, and taxes on lobbying activities, among others.

Also, the organization will owe corporate federal income tax on income unrelated to its tax-exempt purposes, called unrelated business income (UBI). UBI is income generated from routine business activities not substantially related to the entity’s tax-exempt purposes. Learn more about UBI here.

A nonprofit organization – whether a corporation or an unincorporated association –  is not automatically exempt from federal or state taxes. To become exempt, the corporation must meet certain requirements and apply with both the IRS and the Texas Comptroller of Public Accounts.

How Does a Nonprofit Corporation Become a Tax-Exempt Entity?

A nonprofit corporation will apply with the IRS to receive tax-exemption. Many nonprofit organizations qualify for federal income tax exemption under one of 25 subsections of Section 501(c) of the Internal Revenue Code. 

• Many nonprofits are tax-exempt under Section 501(c)(3).
• Many professional associations are tax-exempt under Sections 501(c)(6); others under Sections 501(c)(4) or (c)(5).
• Association political action committees are tax-exempt under Section 527.
• In addition, many 501(c)(6) associations form related educational or charitable foundations exempt under Section 501(c)(3).

The most common section for nonprofit corporations is Section 501(c)(3).  To receive 501(c)(3) tax-exempt status, nonprofit corporations will file IRS Form 1023 to apply. Among other items, it requires the submission of bylaws, state formation documents, detailed pro forma statements, three-year proposed budgets, narrative descriptions of activities, employer identification number, names and addresses of the board of directors, annual accounting period, and type of status seeking: public charity, private foundation, or another status (Learn about the difference between public charities and private foundations here).

Resources

Texas Secretary of State Nonprofit Organizations FAQs

To learn more about the rules and procedures for obtaining a federal tax-exempt status, read IRS publication 557: “Tax Exempt Status for Your Organization.”

To learn more about the rules and procedures for obtaining a state tax-exempt status, read the FAQs at the Texas Comptroller of Public Accounts, Tax Exempt Organizations Section: Frequently Asked Questions About Exemptions.

Learn More: Does A Nonprofit File Tax Returns?

Learn more: How to Become a Nonprofit Corporation

Learn more: How to Apply  for Tax-Exemption with the IRS

We Can Help You

Texas nonprofit attorney Mollie Cullinane of the Cullinane Law Group works exclusively with the nonprofit sector. We help set up and maintain strong and legally compliant nonprofits that have solid bases for long-term success. We provide risk management and offer practical solutions for sound nonprofit governance. We help nonprofits, foundations, religious organizations, and social entrepreneurs throughout the United States who seek to create positive change.