Nonprofit and Tax-exempt: Similar but Different
Many people confuse the terms “nonprofit” and “tax-exempt”. While related, they are not the same.
Nonprofit status is determined by state law and the requirements for nonprofit entities vary from state to state. An organization can be structured as a nonprofit organization but not be tax-exempt. For example, social clubs, recreation clubs, professional organizations, and political organizations exist primarily to benefit its members and do very little, if any, service projects in the community. They can be formed as a nonprofit under state law but not qualify for an exemption from federal income taxes.
Nonprofits are not prohibited from making a profit – indeed many nonprofit organizations generate substantial income – but rather are limited in how the profit may be distributed and taxed. In general terms, the money generated by the organization must support its purposes and cannot be distributed to the organization’s members.
Tax-exempt status is a specific designation in the Internal Revenue Code that exempts a nonprofit entity from paying federal income tax on income substantially related to the entity’s nonprofit purposes. These entities 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 in relation to 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. 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 entity is relatively simple, quick, and inexpensive. In contrast, obtaining tax-exempt recognition involves providing fairly detailed information about your organization to the IRS. The IRS charges an application fee that can be a budgetary challenge for new 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.