Obtaining tax exempt status can be labor intensive and
document will not tell you how to answer every question on the
application. Use the instructions provided by the IRS. Instead, this
article provides background information, suggestions, and tips to help
you understand some of the issues. Our goals is to help you avoid
common booby traps that can torpedo your application.
You can download
& publications directly from the
website maintained by the IRS. CLICK
HERE to go to the IRS download page. Or you can use
free number to order them over the phone 800 829-3676 (allow about two
weeks for delivery). These forms are also available locally from any
IRS walk in office.
for Exempt Status
1023 - Instructions
8718: User Fee
SS4: Application for
Employer ID Number
Exempt Status for Your Organization
DOES TAX EXEMPT
501(c)(3) is a just one of twenty-two different types of
tax exemptions granted by the IRS under section 501 of the
501(c)(3) exemptions are for “charitable, educational, and
religious” organzanations. For reasons discussed below, 501(c)(3)
is the most desirable of all exemptions because of the
“goodies” that come with it. The other (less
desirable) types of exemptions are for organizations such as civic
leagues, social welfare labor unions, business leagues, social clubs,
farmer's coops, etc.
ARE THE ADVANTAGES OF
BEING A SECTION 501(C)(3)
There are two advantages over other types of tax
status, both of
which relate to fund raising ability:
deductible for the donor
organizations qualify for foundation grants.
WHAT IS A
corporations that are "organized and operate exclusively for
charitable, educational, or religious purposes", no substantial part of
whose activities are lobbying or trying to influence legislation, and
which do not endorse political candidates, and no part of whose income
"inures" to the benefit of its members, directors, or others [except as
compensation for services actually performed]. Now let's break this
down and look at each part of the definition as it relates to a
charitable [as opposed to "religious" or "educational"] organizations.
the corporation must be "organized" exclusively for charitable
purposes. To meet this test specific language must be included in the
articles of incorporation stating that  the organization is
organized and operated exclusively for specified charitable purposes;
 none of its earnings or assets can be distributed to officers,
directors or other private individuals [although payment of reasonable
compensation for services is permitted]; and  if it dissolves, the
organization's assets are to be transferred to another charitable
organization (that is, its assets are currently dedicated to charity).
Also, its organizational documents cannot authorize it to engage in
political activities or substantial "lobbying" activities. If these
requirements are met, then the organizational test is satisfied. The
proper working for these paragraphs can be found in IRS Publication 557.
the organization must "operate" exclusively for charitable purposes.
Whether or not you meet this test depends on what you put in the
"narrative" portion of IRS Form 1023 (see below). The following are
recognized by the IRS as charitable purposes:
* Relief of the poor and the underprivilaged. For
providing low income housing, developing employment opportunities, etc.
* Lessening the burdens of government, for example
community social service facilities, supplementing government
* Combating community deterioration. For example,
area revitalization, housing rehabilitation, increasing or improving
housing stock, etc.
* Eliminating prejudice and discrimination. For
operating home purchase programs related to neighborhood integration,
or a minority business assistance program.
It should be recognized, however, that "lessening burdens of
government" and "combating community deterioration" are general
catch-alls which also cover many nontraditional charitable activities.
Therefore, a careful description in the narrative section of your
application is needed of the "charitable purposes" to be achieved
"Exclusively". To be exempt the organization must
"exclusively" charitable (etc.). You would think it
means that an organization can't do anything but conduct charitable
activities. However, the IRS and the courts have interpreted
"exclusively" to mean "substantially". That is, an organization can
carry on "incidental" non charitable activities. For example, a
charitable organization can conduct some business activities that are
unrelated to its charitable purposes without losing its tax exempt
status [see the discussion of "unrelated trade or business" below].
Remember, however, that the IRS will look closely at organizations that
operate in a manner that makes charity appear to be only a secondary
TYPES OF 501(C)(3)
ORGANIZATIONS: PUBLIC CHARITY vs
PRIVATE FOUNDATION -
granting 501(c)(3) status the IRS will classify the organization as
being either a "public charities" or "private
choice is made by the IRS and not the organization.
distinction has to do with the sources of an organization's
support. For example, The Ford Foundation is a
"private foundation" because it does not get any support from the
general public or the government and it is not affiliated with or
controlled by another organization which itself gets public
support. In contrast, your local United Way is a "public
charity" because it receives broad public support and organization that
depends on government grants is a "public charity" because government
grants are considered a public support.
- ADVANTAGES OF BEING A "PUBLIC
foundations have more restrictions on their activities
rules governing the deductibility of contributions are more favorable
for public charities.
public charities there is no tax on its investment income [if it has
any], while a private foundation must pay a 2% tax
IRS considers certain organizations to be public charities simply
by the nature of their activities (schools, hospitals, religious
organizations, etc.) or because the organization is affiliated with or
controlled by another public charity.
most 501(c)(3) organizations, however, the IRS presumes that it
will be a private foundation UNLESS that organization can overcome the
presumption by demonstrating that a sufficient amount of its financial
support comes from "public sources" [small contributions from the
general public, grants from governmental agencies, and grants from
other public charities].
FOUNDATION STATUS: to overcome the presumption an organization
must demonstrate that it receives (or expects to receive) at least one
third of its support from small contributions from the public or from
the government and it does not receive too much income from
investments, it can qualify as a public charity under either of the
following two similar options: Sections 509(a)(1) or Section 509(a)(2).
If the organization does qualify it will not be subject to the
restrictions applicable to private foundations. As you are completing
the application and you are in doubt as to which option to choose, go
with 509(a)(1) or check the box on the application asking the IRS to
decide which of the two is best. They will base their decision on
budget and balance sheet sheet sections of the application. The IRS is
trying to find out where your present financial support comes from and
where you expect to get your future support.
VS. "ADVANCED" RULING: At some point in the application
you will be asked for the type of ruling that you are applying for on
the issue of private foundation vs public charity. A "definitive"
ruling is for organizations who have been in existence for a number of
years. With this type of ruling the IRS would basically be saying "yes,
we can see where your financial support has come from and we have
enough information to make a ruling". New organizations, however, must
ask for an "advanced ruling". Here, the IRS would be basically saying
"you don't have a track record but based on what you said in your
application it looks like you will be a public charity". If an
"advanced ruling" is given the IRS, in granting the exemption, will
designate an "advanced ruling period" of three to five years. At the
end of the "advanced ruling period" you will be expected to submit data
showing where your financial support actually came from.
- LOBBYING: the basic
rule is that a
501 organization cannot attempt to
influence legislation either directly or indirectly. This includes
local legislation pending before a city or county commission. An
"insubstantial" or incidental amount of lobbying is permitted if an
organization is a public charity [see definition below]. These terms
are difficult to quantify. Five percent is sometimes use used as an
informal guideline, i.e., an organization's staff should not devote
more than 5% of its time and or 5% of the organization's annual budget
for lobbying. But this is not an official IRS guideline. However, a
public charity can make lobbying expenditures up to certain specified
levels if it files a special "election" under Section 501 of the
Internal Revenue Code using IRS Form. Even if the organization exceeds
the specified expenditure levels, the worst that can happen is that it
will have to pay a tax of 25% of its excessive lobbying expenditures.
It doesn't lose its exemption unless it keeps exceeding the limits in
ARE NOT TREATED AS "LOBBYING". These
include  talking to legislators about legislation that might affect
an organization's tax exempt status or existence, but this does not
include budgetary or funding matters:  activities related to non
legislative decisions, such as opposing or supporting the issuance of
regulations;  making available the results of nonpartisan studies;
and  responding to requests to testify before legislative committees
[your organization must be invited in writing by the chairman of the
CANDIDATES: Section 501(c)(3)
organizations cannot support or oppose political candidates. No
partisan political campaign activities, however minimal, are allowed.
Section 501(c)(3) groups can distribute nonpartisan "voter education"
information, but such information should be carefully reviewed to make
sure that it is a fair presentation of information about all candidates
and is not "slanted". It cannot be anything that can be construed as an
attempt to persuade the public one way or the other. Also, Section
501(c)(3) organizations are not permitted to allow groups or
individuals to use their facilities and equipment to campaign for
You have to be very careful about making payments to "insiders" (such
as directors, officers, etc.). The IRS will take away your
exempt status if feels that the primary purpose is to benefit
insiders rather that the exclusive furtherance of charitable
purposes. This is called "private inurement". It
many forms. Examples include unreasonably high salary payments and
certain types of business dealings between the corporation and its
directors and officers. This is a MAJOR concern of the IRS
many of the questions on the application (Form 1023) have to do with
potential private inurement.
APPLICATION (FORM 1023)
1: Form 1023
has excellent instructions (a separate document from the form itself).
Follow the instructions given to you by the IRS:
this outline will not
contain a step by step guide for completing the
instructions to Form 1023 carefully. Also, read IRS
- STEP 2 - Employer ID Number:
One of the first questions on the application is
your "Employer Identification Number" (EIN) If you
have one you will need to get it from the IRS. Download Form
SS4 from the IRS website
and follow the instructions. Note: the instructions on Form
tell you how to get your EIN number over the telephone from the IRS if
you are in a hurry. If you do this, however, It is probably a
good idea to first fill out Form SS4 prior to calling (that
you will have done the research before the IRS person starts
peppering you with questions of a technical nature)
3 - Prepare the "Narrative": Part IV of Form
1023 asks you to
describe in detail your organization's past, present, and future
one question [along
with the contents of your articles
of incorporation] will determine whether or not your organization
qualifies for exemption
rest of the
application is merely to determine if there is any improper "private
inurement" (etc) and to determine what type of 501(c)(3) organization
you will be (a "public charity" for a "private foundation").
are some pointers for your "Narrative"
disclose all proposed or existing activities.
Failure to disclose is a crime if your organization plans to implement
an activity that you know is an "unrelated trade or business", consider
"spinning it off" into a separate for profit subsidiary so that you
will not have to include it in your narrative discussion. In such a
case the activity would be carried out by a separate corporation [your
subsidiary] and would not be an activity of the applicant corporation.
If a particular activity is on the borderline and you do not want to
create a subsidiary, give it your best shot. You must fully disclose
the activity. You can put it in the best light and you can give the IRS
your best argument for why it should be considered to be "related" to
your charitable purposes.
Described in detail your proposed or
existing programs. Fully describe the identity of your proposed
customers for clients. Describe eligibility. Describe the physical
facility(ies) that you will use (e.g. location, size, layout, rent,
etc.). Describe your proposed or existing staff. Described in detail
how you will fund your operations. In short, before applying, you will
need to devise a detailed business plan. If you apply without giving
sufficient details, the IRS will hold up your application until you
answer their numerous written questions that they will submit to you
for purposes of getting the detailed information that they will
require. Remember, the IRS does not like to give out
each activity provide the following details
What does the activity entail?
Who conducts the activity?
Where is the activity conducted?
When is the activity conducted?
How significant is the activity in relation to your total
Who may participate in the activities?
How are participants selected?
Are fees charged? If so, please provide a fee schedule.
How does the activity further your exempt purpose?
(g) If activity involves real estate development, give details on
financing, site, etc.
PURPOSES: focus your narrative around
achieving your organizations exempt purposes. If your activities are to
be located in a low income neighborhood, start off your narrative by
using a detailed description of that neighborhood. Include statistics
on the poverty rate, housing conditions, percentage of underwent
mothers, unemployment rates, ethnic breakdown, etc.. In order to
establish how "bad" things are, compare the neighborhood's statistics
to similar statistics for the county or city as a whole. You can get
this data from the City and County Data Book of the U.S. Census Bureau.
Often, the county or city government can give you copies of studies
that they have previously prepared. When describing the activity,
stress over and over how the activity will alleviate poverty and how
the beneficiaries of your services will be low income persons, etc.
don't brag about how you plan to go
down to City Hall and demand better code enforcement in order to clean
up the neighborhood (etc.). This could easily be interpreted by the IRS
to the lobbying. If lobbying will be a major activity for your
cooperation you may not qualify for 501(c)(3) status. Also, don't write
about the benefits that your "members" will enjoy. The activities of
charitable organizations must benefit the entire community and not just
their own members. If only the "membership" were to benefit, the IRS
would interpret the activity as "private inurement" and would
automatically disqualify the corporation. Your members are allowed to
benefit but only as part of the larger community but not as a privilege
inherent in their "membership". If the whole purpose of your
organization is to bring financial benefit to your membership, your
organization probably will not qualify for 501(c)(3) exempt status.
"UNRELATED TRADE OR
describing your activities in the narrative be aware that 501(c)(3)
organizations can not have a "substantial" amount of "unrelated
business activity". Each of your
activities must "relate" to your charitable purpose. In other
words, each activity
must contribute importantly to the achievement of your organization's
charitable objectives as specified in your organization's articles of
incorporation. It is essentially a "purpose" test. For each activity
described in your narrative you must explain why the
organization doing it. Is it doing this to make money or is
this to achieve a charitable goal? To establish that a business
activity is a related business you must be able to show that it is
merely an instrument to achieve a charitable purposes and that the
activity is not an end in
itself. In other words, you must show that the the purpose is
merely to make money (even if that money is to be spent on charitable
purposes the activity
itself must further a
charitable). The bottom
line is the issue of unfair competition. You have to
convince the IRS that the proposed activity is going to be different
from similar activities conducted by non exempt corporations. For
example, perhaps the activity will provide employment to members of the
charitable class. But many non exempt businesses also provide
employment opportunities. You must distinguish what you are proposing
to do. Perhaps your proposed activity can be considered "related" if
the focus is on helping the employees through providing supportive
social services, training, and other assistance that an ordinary
employer normally would not furnish so that it is clear that the
business is not being operated to achieve profits but for other
objectives. The business operation must have factors that make it
different from similar commercial businesses.
FINAL CHECKLIST: send
the following completed and signed
documents to the IRS at the address indicated in form
LETTER: prepare a
short cover letter to be signed by the corporations president
explaining that you are applying for tax exempt status and that your
application is attached. Include the following statement: "the attached
bylaws are a true and correct copy of the bylaws that are currently in
corporation's president should sign on the bottom of the first page.
Attach your articles of incorporation (including a "certificate of
incorporation" sent to you by your state's corporation department) and
8718: Complete the
form and sign it. Attach a check for the application fee that is
indicated on the form. Make the check payable to the "Internal Revenue
The initial response letter: after submitting the application you can
expect a letter from the IRS in about eight weeks. The letter will
acknowledge the receipt of your application. Almost always the letter
will ask you for additional information. If there are only ten or fewer
questions, you are probably in very good shape and you can expect your
application to eventually be approved without too much additional
hassle. If, on the other hand, there are 15 or more questions, there
may be problems with your application. Regardless, answer all questions
truthfully and in detail and submit the answers to the IRS within the
time deadlines imposed on you in the letter. The letter will give you
the name and telephone number of your contact person at the IRS. This
is the person who has actually reviewed your file and who wrote the
letter (although the letter was probably signed by the district
director). It is almost always a good idea to call this contact person
and find out exactly what they want to know. Often these contact people
can be very helpful and the information that they give to you can help
you focus your response to the letter.
Determination letter: eventually the IRS will either send you a
favorable or an unfavorable determination letter. If it is unfavorable,
good luck and you have our condolences. If it is favorable,
congratulations! Save this letter. It is very important. Not only does
it give you critical information about compliance and staying out of
trouble with the IRS, but your potential funding sources will almost
always ask you for a copy of it.
IRS PUBLICATIONS THAT
WILL BE HELPFUL:
Here to go the IRS download page
- Charitable Contributions:Organizations that qualify for
a charity are described. The publication provides rules for determining
the fair market value of donated property and explains limits on the
size of a deduction based on 20, 30, or 50% of an individual's adjusted
- Tax-Exempt Status for Your Organization: Organizations are
through the application procedures for obtaining tax-exempt status.
Generally, these organizations must complete either Form 1023 or Form
1024 and await a ruling or determination letter from the IRS. If an
exemption is granted, it may be effective as of the date of an
organization's formation. In some cases, an organization may be issued
an advance ruling or determination letter prior to commencing
operations. Return and disclosure statements required of exempt
organizations are explained.
- Tax on Unrelated Business Income of Exempt Organization:
- Deductibility of Payments Made to Charities Conducting Fund-Raising
Events:Helps sponsors of fund-raising events carefully word
extent of a donor's eligibility for a charitable contributions
- Charitable Contributions--Substantiation and Disclosure Requirements:The
Revenue Reconciliation Act of 1993's substantiation and disclosure
requirements for donors and charities on contributions made after
December 31, 1993 are reported. It is recommended that charities
familiarize themselves with the new law in order to avoid failure to
meet disclosure provisions that might be subject them to penalties.