Nonprofits and Taxes: 5 surprising facts you should know
Updated September 2022
Many nonprofit organizations receive special tax-exempt status — but not all tax benefits are created equal. While many nonprofit organizations do qualify for tax-exempt status, there are limits to tax advantages and qualifications that each organization must meet. Just because a business is considered to be a nonprofit, it doesn't automatically mean it’s not required to pay taxes on the contributions it receives.
There are more than 1.6 million tax-exempt organizations in the U.S. Yet, whether you’re running a food bank, a youth development organization, or a cultural center, it’s important to know that not all 501(c) organizations are created equal — or have the same tax advantages and rules.
There are many myths surrounding nonprofits and taxes and confusion around nonprofit tax compliance. Below we’ve broken down five surprising things nonprofits may not know about taxes.
#1 - Not all nonprofits are tax-exempt.
If you’re planning to open a nonprofit business or organization, you may think that it will automatically be tax-exempt. However, while qualifying for a 501(c) designation may open the door to tax-exempt status, this is not the case for all organizations. Two main exclusions are religious organizations and public schools.
According to the IRS, “Unlike churches, religious organizations that wish to be tax-exempt generally must apply to the IRS for tax-exempt status unless their gross receipts do not normally exceed $5,000 annually.” While many religious organizations can receive tax-exempt status, certain types of income may still be subject to tax, such as money that comes from indirect or unrelated businesses.
Public schools are treated a bit differently as well, with the IRS stating “If the public school district is an integral part of the municipal government, the public school and any charter school it operates doesn’t qualify for exemption under IRC Section 501(c)(3), because it doesn’t exist separately from the municipal government.” Private schools, on the other hand, may be able to apply for a 501(c) designation if they meet certain guidelines.
#2 - Not every tax-exempt organization can accept tax-deductible contributions.
One of the main perks of nonprofit status for both nonprofit organizations and individuals is having tax-deductible contributions. It’s a win-win situation for everyone. It helps the organization attract charitable donors and also provides the donor with tax incentives.
While you can check an organization’s tax-exempt status using this tool on the IRS website, not every tax-exempt organization is qualified to accept tax-deductible contributions.
| Just because a business is considered a nonprofit, it doesn’t automatically mean it’s not required to pay taxes on the contributions it receives.
Often an organization's eligibility to receive tax-deductible contributions varies based on specific factors. For example, a veterans organization can only receive deductible donations if more than 90% of the organization’s members are veterans.
Organizations that don’t have a charitable mission don’t qualify for tax-deductible donations. Social and recreational clubs may qualify for tax-exempt status, but donations made to these organizations are not tax-deductible.
The Professional Tennis Registry does have tax-exempt status, for example. Its mission is to support tennis instructors, but this is not considered a charitable mission under federal or state requirements. This means that contributions to this organization are not tax-deductible on the donor’s tax return.
Similarly, civic leagues, social welfare organizations, and local associations of employees cannot receive tax-deductible donations, unless they are volunteer organizations that are for social welfare such as volunteer fire departments.
If you’re forming a nonprofit, be sure to take steps to be sure you can receive tax-deductible donations.
#3 - Nonprofits can lose tax-exempt status by not following compliance rules.
If your nonprofit wants to keep its tax-exempt status, you must follow the rules of tax compliance to stay in good standing with the IRS. If not, it’s possible to lose tax-exempt status.
If a nonprofit turns its focus to private interests rather than serving the public, it’s possible to lose tax-exempt status. Another possible way to lose tax-exempt status is for nonprofits to participate in a political campaign, which is a big no-no. Whether directly or indirectly, nonprofits are prohibited from participating in any political campaign.
Also, if nonprofits earn too much money from Unrelated Business Income (UBI) that strays from their mission or they fail to submit an annual return three years in a row, they could be at risk of losing tax-exempt status.
#4 - Some 501(c) organizations may have to pay sales tax.
Being exempt from paying income tax is one benefit of operating a nonprofit, but being exempt from paying sales tax is a whole different beast. It can depend on what you are selling (such as merchandise) and where you are selling it.
Let’s take a look at California, for example. According to the California Department of Tax and Fee Administration, “Although many nonprofit and religious organizations are exempt from federal and state income tax, there is no similar broad exemption from California sales and use tax.”
In California, there are some special exemptions and exclusions available for certain nonprofit and religious organizations establishing they don’t have to pay sales tax. To qualify for an exemption, an organization must be formed and operated for charitable purposes, must also qualify for the welfare exemption from property taxation, and make, prepare, assemble, or manufacture the items it sells or donates. Additionally, an organization must carry out activities to relieve poverty and distress and sell or donate items to assist purchasers or recipients in distressed financial situations.
These regulations, rules, and requirements can vary by state, so nonprofits should check into their state department of revenue to make sure they’re in accordance to avoid any trouble.
#5 - Nonprofits may be more likely to be audited.
Becoming a tax-exempt organization can lead to saving hundreds of thousands, if not millions, of dollars in tax liability. However, this means that some nonprofits can become a funnel for money laundering activities. Because of that, nonprofits face a higher likelihood of being assessed for audit by the IRS. This is done to ensure the organization is following all tax rules.
It is paramount to keep organized financial and business records and to stick to your organization’s stated mission to avoid any potential IRS triggers. Having any sort of discrepancy between income and expenses or earning too much money from unrelated business income can also be a red flag.
Being audited is no one’s idea of a good time, so it’s worth it to put the effort upfront to keep good records and manage tax compliance correctly.
Helping nonprofits stay on top of taxes
Nonprofits can do a lot of good for their communities and for society as a whole. Because of this, they have a lot of tax advantages that can be utilized to support their mission, vision, and values. However, applying for these exemptions can mean a lot more paperwork and require more effort regarding tax compliance.
Staying on top of annual returns, keeping clean and organized records, and focusing on your mission can help you minimize risk and tax trouble down the line.