What is the difference between “Nonprofit” and “Tax-exempt”?

Is there a difference between a “nonprofit” and a “tax-exempt” entity?  Yes.  While the terms are related, not all nonprofits are tax-exempt.  Knowing the difference is important to directors, managers, and even donors.

What is a Nonprofit?

“Nonprofit” refers to a type of entity.  Though each state has its unique requirements, “nonprofit” means the organization must use all of its profits to provide its nonprofit services.  While a for-profit business can pay its owners and employee whatever it wants and can pay out dividends and shares of stock, a nonprofit cannot.

A “nonprofit” can be a corporation, a limited liability company (LLC), or an association.  While they are commonly corporations, the IRS and many states now allow nonprofit LLCs.

Nonprofits can be a traditional charity, such as a school, hospital, and volunteer fire departments.  Many people are surprised to learn they can also be social clubs, sports clubs, professional organizations, political organizations, veterans’ clubs, and more.

Misconceptions about Nonprofits

Nonprofits are not prohibited from making a profit.  This is a common misperception.  Indeed, many nonprofit organizations generate substantial income.  Rather, nonprofit organizations are limited in how the profit may be distributed and how it is taxed.

In general terms, the money generated by the nonprofit must support its purposes and cannot be distributed to the organization’s members.  For example, a veterans’ club must use its money to support veteran-related causes.  It cannot use the proceeds to operate a school or fire department or health clinic (although it could set up a separate business to do those services).

There are exceptions to the limitation on the use of funds.  For example, nonprofits can pay fair market value compensation for work performed.  They can reimburse directors and employees for expenses incurred for their duties, such as attending a training.  Nonprofits can use their fund to buy items, rent buildings, and advertise.  They can do this even if those items may not be part of the nonprofit’s core mission because they are necessary to the mission.

What is Tax-exempt status?

“Tax-exempt status” is a specific designation in the Internal Revenue Code that exempts a nonprofit organization from paying federal income tax on income substantially related to the organization’s nonprofit purposes.

Tax-exempt nonprofits are still subject to many other taxes, such as payroll, unemployment, and worker’s compensation taxes. They can even be subject to sales and use taxes and property taxes.

You may hear the term 501(c)(3) status concerning nonprofits. This term refers to the specific section in the Internal Revenue Code that grants tax-exempt status to certain charitable, educational, or religious organizations.

Is “Tax-exempt” the same 501(c)(3)?

Not all tax-exempt entities are exempt under section 501(c)(3). There are other types, such as 501(c)(4) (for example, social welfare organizations) and 501(c)(6) (for example, chambers of commerce).

The requirements for tax-exempt status are often more stringent than those for obtaining nonprofit recognition by your state. Forming a nonprofit organization is relatively simple, quick, and inexpensive.  In contrast, obtaining tax-exempt status involves providing detailed information about your organization to the IRS.

The IRS charges an application fee that can be a budgetary challenge for new nonprofit organizations. It can take several months, or even a year, to receive approval. Due to the complexity surrounding tax-exempt status, it is advisable to engage professional assistance before beginning the time-consuming and expensive process of applying for tax-exempt status.

Contact Concerto Law to set up your Nonprofit or Tax-exempt Organization

We have helped dozens of Pennsylvania nonprofits form their organization and obtain IRS tax-exempt status.  We take the guesswork out of it and can create your new nonprofit within a few days.  Contact Attorney Christine Kuntz at (814) 706-1288 to set up an appointment.