Nonprofit versus Tax-exempt: What is the difference?

What is the difference between a nonprofit and a tax-exempt organization?  Many people confuse the terms “nonprofit” and “tax-exempt”.  Some believe they are the same while others believe they are different.  The truth is that, while related, they are not the same.

Nonprofit status is determined by state law and the requirements for nonprofit organizations vary from state to state. They can be structured as a nonprofit organization but not be tax-exempt (i.e. exempt from paying federal income tax).  For example, social clubs, recreation clubs, professional organizations, and political organizations exist primarily to benefit its members.   These clubs, however, do very little, if any, charitable works, such as service projects in the community.  They can be formed as a nonprofit organization under state law but not qualify for an exemption from federal income taxes.

Nonprofits are not prohibited from making a profit .  This is a common misperception.  Indeed, many nonprofit organizations generate substantial income.  Rather, nonprofit organizaitons are limited in how the profit may be distributed and how it is taxed.  In general terms, the money generated by the organization must support its purposes and cannot be distributed to the organization’s members.  There are exceptions, however, such as fair market value compensation for work performed. A common example is an employee who is also a member of the organization.

 

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. These 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 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 organization is relatively simple, quick, and inexpensive.  In contrast, obtaining tax-exempt status 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 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.

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