501(c)(3) Organization Rules

by Danielle Smyth - Updated July 31, 2018
Female volunteers packing soup containers into crate in soup kitchen

If your organization is not-for-profit, you may wish to file for 501(c)(3) status in order to become tax exempt. An exemption of this kind can go a long way toward helping nonprofit organizations make ends meet, since the money earned by a not-for-profit is usually earmarked for the cause the organization supports. Ensuring that you properly follow 501(c)(3) requirements is critical, however, in order to avoid any tax or legal penalties down the line. These requirements range from those related to paying employees or contractors, choosing and compensating board members and ensuring that you properly file taxes each year.

501(c)(3) Application

In order to be considered for 501(c)(3) status, an organization must complete a 501(c)(3) application with the IRS. Before even beginning this process, your organization must be recognized as a trust, an association or a corporation. If you have not yet filed for one of these, you must do so before applying to become a 501(c)(3) organization.

You’ll also need to include in your application a thorough description of the activities you are proposing that your organization will carry out. This will provide the IRS with a sense of the purpose of your nonprofit organization and why it would benefit from being tax-exempt. In addition, you must specify a tax-exempt purpose. These are outlined in IRS Publication 557.

Tax-exempt purposes, according to the IRS, include those organizations classified as charitable, religious, educational, scientific, literary, public safety, amateur sports and the prevention of cruelty to children or animals. They define charitable to mean providing aid to the poor, distressed or underprivileged. The advancement of religion or education, the elimination of prejudice or discrimination or the defense of civil rights are all considered viable tax-exempt purposes. Reviewing a 501(c)(3) nonprofit organization list may help you to determine whether yours might be considered acceptable.

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The application to be classified as a 501(c)(3) requires a number of forms to be completed. It is possible to include your power of attorney information if you expect that your organization will be represented by a professional for legal advice in the future. By providing these details, you are authorizing your attorney to speak on your behalf with the IRS about your application and tax-exempt status.

When you submit your 501(c)(3) application, you will be required to supply a user fee. Depending on the type of organization you have, this will cost anywhere from $275 to $600. Ensuring that this amount is paid and that your application is complete is very important in order to facilitate a speedy application review and approval. Don’t forget to include your employer identification number if you have one. If not, you should apply for one before submitting your paperwork to the IRS. If you do omit certain information in your application, the IRS will return it to you for editing rather than just automatically rejecting it.

Along with your application, you will need to submit exact copies of your group’s organizing documents. If your group is a corporation, for instance, these might be your articles of incorporation. If your organization hasn’t existed for at least three tax years, you’ll need to provide the current year’s financial information and a proposed budget for the next two years, including all revenue and expenses.

Finally, there are specific locations to which your application must be submitted, depending on the way you will be having it delivered. Express mail and other services must be sent to a different delivery address than standard U.S. mail, so be sure to refer to the IRS website for the correct address before sending your application.

If your application is approved, you will receive a determination letter from the IRS outlining your permissions as a 501(c)(3) organization. Generally, the letter is usually effective as of the date of the organization’s formation, provided that the application was submitted within 27 months of its founding.

If your application to become a 501(c)(3) organization is denied, the IRS outlines an appeal procedure. You may submit a statement fully explaining the reasons behind your appeal within 30 days of receiving your determination letter. In the statement, you must specifically indicate whether you wish to have appeals office consideration. At this stage, you may also seek representation by a trustee or principal officer of the organization or by an attorney, certified public accountant or other trusted figure.

501(c)(3) Rules

In order to be considered tax-exempt by the IRS, your organization must be operated exclusively for purposes as outlined in section 501(c)(3) of the Internal Revenue Code. At no time is it permissible for your group’s earnings to be given to a shareholder or individual. The IRS also stipulates that organizations of this type cannot focus primarily on lobbying or an attempt to influence political candidates.

Generally speaking, a 501(c)(3) organization is arranged for a charitable purpose. It cannot be arranged in an effort to benefit private interests or to earn a profit. If the IRS determines that the organization has violated these rules, various taxes and penalties may be levied on any of the organization's income.

When filing taxes, nearly all 501(c)(3) organizations are required to submit a form called the Annual Exempt Organization Form. This does not apply to churches, other religious groups or certain state institutions. Careful recordkeeping is essential in order to ensure that these filings are as accurate as possible. Failure to properly document and report the organization’s spending and earning could result in a reversal of its 501(c)(3) status or the levying of tax penalties. If your organization’s tax-exempt status is ever revoked, you may be required to file a tax return such as those used for corporations, estates or trusts.

501(c)(3) Member Salaries

Payroll for nonprofits is a bit of a tricky issue, largely because there are different rules that apply to these organizations than those that apply to traditional for-profit companies. On a basic level, the most important thing you can do to ensure that your organization operates above board is to familiarize yourself with the rules regarding salaries and follow them exactly. In addition, careful recordkeeping is essential so that you are able to document what funds were paid to which employees. That being said, those who work for not-for-profits absolutely can and should be paid. The essence of the organization is that as an entity it cannot turn a profit, but those who make it function aren’t expected to be volunteers.

In most instances, it may be best to pay workers as employees rather than subcontractors. Regardless of your organization’s nonprofit status, the IRS still requires you to abide by the rules that dictate whether a worker is a contractor or an employee. They use a 20-point test to evaluate the true status of a worker, including questions like whether the individual receives employee-like benefits or whether the organization has a right to control how the worker does his job. If you decide to classify workers as contractors and the IRS later determines that you should have labeled them employees, you will be responsible for the employer portion of any applicable payroll taxes. Consulting with an accountant and a tax professional before making decisions of this nature is a good idea.

In addition, determining how to compensate employees of a 501(c)(3) can be challenging. For-profit organizations have a variety of options, including hourly wages, salaries or base plus commission. Due to the nature of nonprofit organizations, it can be viewed as a conflict of interest if employees are to be compensated with any sort of commission or percentage of earnings. Not only can this raise potential red flags with the IRS, this sort of compensation structure may tend to encourage behavior that your organization would not support, including improper or fraudulent actions.

501(c)(3) Board Members

A board of directors is an essential part of a not-for-profit organization. Members of this governing council help to make important decisions for the organization so that it can remain on track and stay focused on its greater purpose. Positions on a 501(c)(3) board of directors are usually temporary and are often elected or are otherwise volunteer positions.

It’s best if members of the organization’s board are not also employees. This helps to avoid any conflicts of interest. The organization may also choose to have elected or appointed officers as a part of the board of directors. Any positions of this nature should be outlined in the organization’s bylaws or articles of incorporation.

When it comes to reimbursement for board members, the IRS has guidelines in place to prevent any questionable behavior. If a nonprofit organization pays its board members more than $600 in a given calendar year, the nonprofit must issue a 1099 form to those individuals for inclusion in their taxes. Many organizations choose not to reimburse board members, and those who serve in these positions are often happy to do so for exposure, to help others or as a way of gaining further experience in the field.

Board members are permitted, according to the IRS, to deduct expenses in the same way that an independent contractor could. These expenses include mileage or other costs associated with travel.

Can a Nonprofit Make Donations?

It is possible for a not-for-profit organization to donate money to other nonprofits. However, since the funds your organization has were likely donated with the intent that they would be used to further its purpose, allocating those funds to another nonprofit can get complicated. If certain rules are followed, however, this sort of donation is within the realm of the law.

If you will be donating money to another nonprofit, first be sure that there are no conflicts of interest. No one at your organization or the other organization or their friends, families or businesses can benefit in any way from the donation. Second, check to be sure that the funds you’re donating weren’t given to your organization with restrictions. Sometimes, donors will provide funds with the caveat that they only be used in a particular way. If that’s the case, you must only use them as directed, and you cannot donate those particular funds to another organization.

It’s also a good idea to get to know the financial plans and well-being of the 501(c)(3) to which you plan to donate. It could reflect poorly on your organization if you gave a significant amount of money to a group that, it turned out, was struggling financially due to mismanagement or illegal treatment of funds.

In addition, you should consider the well-being of your own organization. Before donating any money to another 501(c)(3), be sure that there’s no way that doing so could possibly endanger your own nonprofit. The donation shouldn’t run counter to the values of your organization, as that could have a negative impact on your reputation or public persona. In addition, you should verify that the other organization is in no way in competition with your organization or the purpose of your organization. After all, the health and reputation of your nonprofit should come first.

About the Author

Danielle Smyth, MS, is a writer and content marketer from upstate New York. She owns her own content marketing agency and works with a number of small businesses to develop B2B content.

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