501(c)(3) Organization

What Is a 501(C)(3) Organization?

Section 501(c)(3) is a portion of the U.S. Internal Revenue Code (IRC) and a specific tax category for nonprofit organizations. Organizations that meet Section 501(c)(3) requirements are exempt from federal income tax. While the Internal Revenue Service (IRS) recognizes more than 30 types of nonprofit organizations, organizations that qualify as 501(c)(3) organizations are unique because donations to these organizations are tax-deductible for donors.

In general, there are three categories of organizations that may be eligible for the tax category outlined in Section 501(c)(3) of the IRC: charitable organizations, churches and religious organizations, and private foundations. The rules outlined in Section 501(c)(3) are regulated by the U.S. Department of Treasury through the Internal Revenue Service (IRS).

Key Takeaways

  • Section 501(c)(3) is a portion of the U.S. Internal Revenue Code (IRC) and a specific tax category for nonprofit organizations.
  • Organizations that meet the requirements of Section 501(c)(3) are exempt from federal income tax.
  • While the Internal Revenue Service (IRS) recognizes more than 30 types of nonprofit organizations, organizations that qualify as 501(c)(3) organizations are unique because donations to these organizations are tax-deductible for donors.
  • 501(c)(3) organizations must pay their employees fair market value wages.
  • To receive its favorable tax treatment, the non-profit organization must not deviate from its purpose or mission.
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What Is a 501(C) Organization?

How a 501(c)(3) Organization Works

To be considered a charitable organization by the IRS, an organization must operate exclusively for one of these purposes: charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals.

Furthermore, the IRS defines "charitable" activities as relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law, and combating community deterioration and juvenile delinquency.

Requirements of a 501(c)(3) Organization

To be tax-exempt under Section 501(c)(3), an organization must not be serving any private interests, including the interests of the creator, the creator's family, shareholders of the organization, other designated individuals, or other persons controlled by private interests. None of the net earnings of the organization can be used to benefit any private shareholder or individual; all earnings must be used solely for the advancement of its charitable cause.

The 501(c)(3) organization is also forbidden from using its activities to influence legislation in a substantial way, including participating in any campaign activities the support or deny any particular political candidate. It is typically not permitted to engage in lobbying (except in instances when its expenditures are below a certain amount).

People employed by the organization must be paid solely based on the fair market value that the job function requires, with no expectation of bonuses or compensation.

Once an organization is categorized as a 501(c)(3), the designation remains as long as the organization exists, unless it is revoked by the IRS.

To remain tax-exempt under Section 501(c)(3), an organization is also required to remain true to its founding purpose. If an organization has previously reported to the IRS that its mission is to help less privileged individuals gain access to a college education, it must maintain this purpose. If it decides to engage in another calling—for example, sending relief to displaced families in poverty-stricken countries—the 501(c)(3) organization has to first notify the IRS of its change of operations to prevent the loss of its tax-exempt status.

While some unrelated business income is allowed for a 501(c)(3) organization, the tax-exempt charity may not receive substantial income from unrelated business operations. This means that the majority of the firm’s efforts must go towards its exempt purpose as a non-profit organization. Any unrelated business from sales of merchandise or rental properties must be limited.

While organizations that meet the requirements of Section 501(c)(3) are exempt from federal income tax, they are required to withhold federal income tax from their employees’ paychecks. There are some exceptions to this withholding rule; for example, if the employee earns less than $100 in a calendar year.

Special Considerations

Organizations that meet the 501(c)(3) tax category requirements can be classified into two categories: public charities and private foundations. The main distinction between these two categories is how they get their financial support. 

A public charity is a nonprofit organization that receives a substantial portion of its income or revenue from the general public or the government. At least one-third of its income must be received from the donations of the general public (including individuals, corporations, and other nonprofit organizations).

If an individual donates to an organization that is considered a public charity by the IRS, they may qualify for certain tax deductions as a donor that can help them lower their taxable income. Generally, donations to a tax-exempt, public charity under section 501(c)(3) are tax-deductible for an individual for up to 50% of their adjusted gross income (AGI).

Private Foundations

A private foundation is typically held by an individual, family, or corporation, and obtains most of its income from a small group of donors. Private foundations are subject to stricter rules and regulations than public charities. All 501(c)(3) organizations are automatically classified as private foundations unless they can prove they meet the IRS standards to be considered a public charity. The deductibility of contributions to a private foundation is more limited than donations for a public charity.

To apply for tax-exempt status under section 501(c)(3), most nonprofit organizations are required to file Form 1023 or Form 1023-EZ within 27 months from their date of incorporation. The charitable organization must include its article of incorporation and provide documents that prove that the organization is only operating for exempt purposes.

However, not all organizations that qualify for the tax category need to submit Form 1023. For example, public charities that earn less than $5,000 in revenue per year are exempt from filing this form. Even though it is not required, they may still choose to file the form to ensure that donations made to their organization will be tax-deductible for donors.

Advantages and Disadvantages of a 501(c)(3) Organization

The 501(c)(3) status offers a myriad of benefits to the designated organizations and the people they serve. For example, 501(c)(3) organizations are exempt from paying federal income and unemployment taxes, and patrons who donate to them are allowed to claim a tax deduction for their contributions.

To help with funding and further their mission, these organizations are eligible to receive government and private grants. To qualify, the organization must have a need for and a mission aligned to the purpose of the grant.

In addition, 501(c)(3) organizations often receive discounts from retailers, free advertising by way of public service announcements, and food and supplies from other non-profit organizations designed to help in times of need.

A 501(c)(3) could be the lifelong dream of its founder; however, once established as a 501(c)(3), it no longer belongs to its founder. Rather, it is a mission-oriented organization, belonging to the public. To maintain its favorable tax treatment, it must operate within the confines of the law pertaining to 501(c)(3) organizations.

Because the organization serves the public, it must operate with full transparency. Therefore, their finances, including salaries, are available to the public and subject to their review.

Pros
  • Exempt from federal taxes

  • Contributions are tax deductible

  • Eligible for government and private grants

Cons
  • Does not belong to those who created it

  • Restricted to specific operations to receive tax exemptions

  • Financial information is accessible by the public

Example of a 501(c)(3) Organization

The American Red Cross, established in 1881 and congressionally chartered in 1900, is one of the United States' oldest non-profit organizations. The Red Cross's mission is to prevent and alleviate "human suffering in the face of emergencies by mobilizing the power of volunteers and the generosity of donors." And since its inception, its goal remains to serve members of the Armed forces and provide aid during disasters.

Located in more than 200 countries, the Red Cross operates the largest network of volunteers in the world. This 501(c)(3) organization is segmented into three divisions: The National Red Cross and Red Crescent Societies, the International Federation of Red Cross and Red Crescent Societies, and the International Committee of the Red Cross.

The National Red Cross and Red Crescent Societies, which include the American Red Cross, aim to relieve human suffering globally by empowering subordinate organizations to operate within its nation's borders to provide disaster relief, education, and other related services.

The International Federation of Red Cross and Red Crescent Societies provide global humanitarian aid during peacetime, such as assisting refugees. The International Committee of the Red Cross provides humanitarian relief for people affected by war or other armed conflicts.

As a 501(c)(3) organization, patrons can contribute to the Red Cross and receive a tax deduction. Taxpayers claiming the standard deduction on their tax return may claim up to $300 of their 501(c)(3) contributions as a tax deduction, according to the CARES Act.

501(c)(3) FAQs

How Do You Start a 501(c)(3)?

To create a 501(c)(3), you must define the type of organization and its purpose or mission. Before selecting a name, search to ensure that it is not taken. If available, secure the name by registering it with your state. Otherwise, secure the name when filing the articles of incorporation. The articles of incorporation must be filed with the state in which it will be organized and according to the state's rules for non-profit organizations.

After filing, apply for the 501(c)(3) IRS exemption (Form 1023) and state tax exemption for non-profit organizations. Upon completion, create your organization's bylaws that specify how the organization will be structured and governed. Finally, appoint and meet with your board directors.

How Much Does It Cost to Start a 501(c)(3)?

The costs associated with creating a 501(c)(3) vary according to the needs of the organization. However, some costs can be approximated. For example, filing the articles of incorporation with the state typically costs about $100. The IRS Form 1023 filing fee is $600. However, for organizations that expect less than $50,000 in annual earnings, Form 1023 EZ can be filed for $275.

How Long Does It Take to Get a 501(c)(3) Determination Letter?

A 501(c)(3) determination letter is sent after applying for the 501(c)(3) exemption with the IRS . It takes approximately three to six months to receive this letter after filing.

Do You Need to Be a Corporation to Get a 501(c)(3)?

According to the IRS, to qualify for the 501(c)(3) status, the organization must be formed as a "trust, corporation, or association."

What Is the Difference Between a 501(c)(3) and a 501(c)(4)?

A 501(c)(3) organization is a non-profit organization established for religious organizations (e.g., churches), charities, and certain educational institutions. These organizations are prohibited from engaging in lobbying. Alternatively, 501(c)(4) organizations, which are social welfare groups, are allowed to engage in lobbying.

The Bottom Line

501(c)(3) organizations are non-profit organizations, established around a mission. Most people are familiar with 501(c)(3) organizations existing as churches and charities, but they also include private foundations. As long as they operate to support their mission, they receive favorable tax treatments, such as avoiding federal income and unemployment taxes.

Article Sources

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