It's actually impossible to become a 401(c)(3) organization because they don't exist. It's a common misnaming of the 501(c)(3) classification for tax-exempt organizations. If you qualify as a 501(c)(3) organization, donations to your company become tax deductible, which is an incentive for people to open their wallets.
Not every charitable or nonprofit group qualifies. You can learn the details of becoming a 501(c)(3) in IRS Publication 557.
TL;DR (Too Long; Didn't Read)
A 401(c)(3) organization is just a misnomer for an IRS-qualified 501(c)(3) tax-exempt organization. To qualify as a 501(c)(3), you must form a corporation, association or trust under the laws of your state and then apply for tax-exempt status. You submit your application to the IRS on Form 1023 or 1023-EZ along with your nonrefundable application fee.
The Purpose of 501(c)(3) Groups
Federal tax law only allows an organization to become a 501(c)(3) if the organization's mission fits a list of acceptable purposes:
- Testing for public safety
- Prevention of cruelty to animals
- Preventing child abuse and mistreatment
- Supporting national or international sports competition
"Charitable" is a legal term that includes multiple categories:
- Relief of the poor or underprivileged
- Advancement of religion
- Advancement of education or science
- Erecting or maintaining public buildings or monuments
- Lessening the burdens of government
- Lessening neighborhood tensions
- Eliminating bigotry
- Defending human rights
- Combating juvenile delinquency
The IRS has a full list of the various types of 501(c)(3) organizations in Publication 557.
Appropriate Legal Structure
Your organization has to incorporate to qualify unless it's a trust or an unincorporated association. If you're a sole proprietorship, a partnership or just a loosely organized group of people with a common charitable goal, you can't qualify as a 501(c)(3). The difference between a loosely organized group and a nonprofit unincorporated organization can be hard to define.
The law says you can become an unincorporated association even if you haven't filed any paperwork. It's similar to the way two people who go into business together legally become a partnership even if they don't file any paperwork. To qualify as a 501(c)(3), you do need to have some sort of paperwork, such as a charter or other organizing document.
While this is a simpler route than incorporating, it's also riskier. In many states, there's no legal distinction between an unincorporated association and its members, which means creditors could sue for your assets.
Limits on Activities
The rules for 501(c)(3) organizations also include several things you're forbidden from doing if you want to qualify:
- None of the money you raise can go to private shareholders nor can you operate for the benefit of private individuals.
- You can pay your staff but only with reasonable compensation for the work.
- Lobbying for or against legislation can't be a major part of your activities.
- You can't participate in campaign activity for or against political candidates.
- The organization doesn't engage in "excess benefit transactions" such as allowing directors to spend the nonprofit's funds on themselves.
Breaking the rules down the road can lead to your group losing its tax-exempt status.
Preparing to Apply to the IRS
To become a tax-exempt 501(c)(3), the first step is to organize. If you're a corporation, for instance, you need to file the appropriate paperwork with your state's government, typically the secretary of state's office. Other types of organizations will have different procedures to establish themselves.
Once your state signs off and legitimizes your organization, you can begin the federal application process. If you're not sure whether you'll qualify, the IRS has an online questionnaire you can use to review the basic requirements, such as the right legal structure and a tax-exempt purpose. If you find out in advance that you don't qualify, that saves you from filing the 28-page application form and paying the application fees in a doomed effort.
Using Form 1023
Most aspiring 501(c)(3) organizations have to submit IRS Form 1023. Groups with assets of $250,000 or less and annual gross receipts of $50,000 or less can use the streamlined Form 1023-EZ. Religious institutions such as churches or mosques and groups with gross receipts under $5,000 don't have to file 1023 at all.
The form requires exhaustive information on your nonprofit and may take more than 100 hours to complete. Information includes:
Basic name, address and primary contact information along with the name of anyone helping you set up your group.
such as an attorney or accountant
Your organizational structure: trust, corporation, unincorporated association and so on. If you have bylaws, you need to include them with your submission.
What is your exempt purpose? Along with a basic statement on the form, you need to attach a more detailed review of your past, present and planned future activities.
Compensation and financial arrangements with directors and employees. The form has a lot of added questions, such as whether any directors are related to each other.
Detailed information about money management including membership fees, donations, revenue from merchandise sales, your expenses and your assets
* Depending on whether you're a church, school or other tax-exempt group, there will be more questions specific to that kind of organization.
Currently, you will submit a fee of $600 along with your paperwork. The 1023 EZ, which takes less than 20 hours, costs $275. You don't get a refund if the IRS rejects your application.
History and Finances
The IRS requires your Form 1023 to include information about revenues and expenses, but the specifics vary depending on how long you've been around.
- If you've been in existence for less than one year, provide projections of your income and expenses for this year and the following two years. This has to be a reasonable and good faith estimate.
- If you've been around less than five years, provide income and expenses for each year plus projections for the future. The IRS wants a total of four years. If this is your second year of operation, you'll need projections for the next two years, for instance.
- After five years of operations, you provide financial information for your most recently completed year and the three preceding years. Add information for a fifth year in a separate statement.
Mistakes to Avoid
With an application as big as this, it's no surprise that people screw it up. The IRS has a list of common mistakes to avoid. After you complete your application package, go over the list and double check that you got everything right:
- Did you provide the names, addresses, titles and compensation of the principal officers and board of directors?
- Did an authorized individual such as a director or principal officer sign the form? A principal officer would be the president, vice president, secretary or treasurer. Electronic and faxed signatures aren't acceptable.
- Did you submit a copy of any bylaws or regulations you've adopted?
- Did you include all the detailed financial information for which 1023 asks?
- Does the package include the month that the annual accounting period ends?
- Have you attached all the supporting data and schedules?
- Have you completed all the required pages?
- Does the detail on your organization's activities show how you're working toward your goals?
- Did you attach a copy of any organizing documents and amendments?
- Did you include the check to pay fees?
- IRS Tax Lawyer: IRS 401C3 Tax Regulations
- IRS: Exemption Requirements - 501(c)(3) Organizations
- IRS: Lifecycle of an Exempt Organization
- IRS: Tax-Exempt Status For Your Organization
- IRS: Section 3. Religious, Charitable, Educational, Etc., Organizations
- IRS: "Charitable" Purposes
- Journal of Accountancy: CEO of Tax-Exempt Organization Hit With Excess Benefit Taxes
- Foundation Group: How to Pay Your Nonprofit's Staff
- Charity Lawyer: What Is An Unincorporated Nonprofit Association?
- IRS: Instructions for Form 1023
- IRS: Form 1023
- Nonprofit Elite: How Much Does it Cost to File for 501c3 Tax Exemption
- IRS: Top Ten Tips to Shorten The Tax-Exempt Application Process