IRS Tax-exemption: Navigating the Application Process
Attorneys are often asked to navigate the tax-exemption applicaition process. The applications are lengthy. There are different types of applications (IRS Form 1023 Application, IRS Form 1024 Application, and the newer IRS Form 1023EZ application). Additionally, compiling the data and submitting the attachments can be overwhelming.
Unfortunately for most nonprofits, the Form 1023 and Form 1024 applications are a necessary burden. The gold standard for most nonprofits is to obtain status as a federal tax-exempt organization. Federal tax-exempt status exempts entities from paying federal income tax on profits that are substantially related to the entity’s purpose. This does not exempt the entity from all taxes, and the entity will still be obliged to pay employment-related taxes (payroll, unemployment, worker’s compensation taxes) and may even pay property taxes, sales and use taxes, and unrelated business income tax.
While understanding the benefits of tax-exemption is easy, it is much more complicated to know which application to use and how to complete it. Let’s begin by learning which application to use.
Form 1023 or Form 1024: Which Do We Use?
There are two applications for requesting exemption from federal income tax.
The most commonly used application is the IRS Form 1023 Application For Recognition of Exemption Under Section 501(c)3) of the Internal Revenue Code (commonly called “the 1023 Application”. This application is only for groups organized exclusively for religious, charitable, scientific, public safety, literary, educational, amateur sport, or prevention of cruelty to animals purposes. If this is not your exclusive purpose, you cannot use the 1023 application.
The IRS Form 1024 Application For Recognition of Exemption Under Section 501(a) (the “1024 Application”) is used by all other groups that may be eligible for a tax-exemption. There are more than a dozen possible classifications. Common ones include: civic groups, labor organizations, chambers of commerce, social clubs, and veterans organizations.
IRS Form 1024 Application for Exemption
Use the IRS 1024 Application when you are applying for an exemption under any classification other than section 501(c)(3). This is a lengthy, detailed application that asks about your governing body (board of directors/trustees), current and projected finances, agreements with related parties, sources of income, and property owned by the organization. You must submit copies of your bylaws and organizing documents. You must also prepare a detailed statement of your organization’s activities. This is perhaps the most important part of the application as it is used to determine whether your organizations qualifies for a tax exemption. It is important to seek assistance from experienced counsel when completing this application.
IRS Form 1023 Application for Exemption
IRS Form 1023-EZ Responding to complaints that the 1023 application was too cumbersome for small nonprofits, the IRS developed the 1023-EZ application. This is a short (three page) application to be used by charities that (1) project their annual gross receipts will not exceed $50,000 in each of the next three years, and (2) have total assets worth no more than $250,000. Use of this form is not mandatory and small nonprofits may elect to submit the longer, more comprehensive form. In addition, certain nonprofits, such as hospitals, schools, and limited liability companies, are not permitted to use the 1023-EZ.
The filing fee is approximately $400. The IRS periodically increases its application fees, so be sure to carefully review the application and verify the current fee.
IRS Form 1023
This is a lengthy (26 page) application that provides a comprehensive view of the applicant. Applicants must provide information regarding its organizational structure, finances, and governance. Many questions require submission of written responses or documents.
The filing fee is approximately $850 for organizations with annual receipts that exceed or are expected to exceed $10,000 annually over a four-year period, and $400 for smaller organizations. The IRS periodically increases its application fees, so be sure to carefully review the application and verify the current fee.
Form 1023EZ v. the Advantages of the (Longer) IRS 1023
Although your nonprofit may qualify to use the 1023-EZ form, there are advantages to using the more comprehensive 1023 form. While it is simpler and cheaper to file the shorter application, the 1023-EZ does not inquire into your organization’s governance policies or finances. It can be extremely beneficial to a fledgling organization to answer these questions. Not only do they prompt the organization to review and develop pertinent governance and financial safeguards, but they prepare the organization for operating in a ethical and legally-compliant manner.
Another reason to consider the longer version: organizations that intend to seek grant funding will often be asked similar questions by the funding sources. Organizations with experience in responding to these inquiries will be much better prepared than those that filed the 1023-EZ application. Lastly, the 1023-EZ application is approved in a rather perfunctory manner and does not face the substantive review of the longer 1023 application. Some donors are comforted to know your organization’s application received the IRS’s enhanced scrutiny.