What “Tax Exempt” Really Means for California Nonprofits

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Managers of nonprofits can sometimes be surprised to learn that their organization’s tax-exempt status does not free it from all forms of tax. At the planning stage, accounting for a nonprofit’s tax treatment should be a central concern. In addition to complying with the requirements to obtain tax-exempt status, organizers also need to take into account taxes and tax compliance steps that will apply to the organization even after it qualifies for an exemption.

“Tax exempt” is mostly about income tax

When people talk about a nonprofit’s tax-exempt status they are referring to a basket of tax privileges provided by federal and state law. By far the most important component in this basket is the exemption from income tax. Nonprofits that can satisfy the requirements to fit within one of the numerous categories under Section 501(c) of the Internal Revenue Code can apply for, or in some cases automatically qualify for, exemption from paying federal income tax. The most common type of 501(c) organization is the familiar 501(c)(3) charity, but the section includes other organizations, such as churches.

California law often mirrors federal rules, but in each case a nonprofit needs to be sure to analyze its structure and goals under both federal and state law to ensure that it meets the exemption requirements. Note that the state has its own processes for granting nonprofits tax-exempt status that must be separately complied with. Failing to do so could expose the organization to state income tax, even though it is exempt from paying federal income taxes.

California nonprofits can still have a range of tax compliance obligations

California nonprofits are potentially subject to a range of tax compliance requirements. The specific tax steps that a nonprofit must take depend on the details of the organization and its operations. Here are a few examples:

  • Filing annual tax returns. It can come as a surprise to learn that even an organization that is exempt from paying sales taxes still must file annual tax returns with the IRS. Such returns are largely informational, but they can involve important categories that in some cases create tax liability despite the “tax exempt” status of the organization.
  • Employment taxes. Like all employers a nonprofit must pay the taxes associated with its payroll. “Employment tax” is an umbrella term capturing a range of distinct tax regimes. It includes federal, state, and local income tax withholding requirements, Social Security taxes, and Medicare tax. Nonprofits that will have employees should consult with an employment specialist to prepare to comply with each of these requirements.
  • Sales and use taxes. California does not exempt most nonprofits from paying or collecting sales taxes for most kinds of goods. Although sales tax can be passed on to customers who buy goods, an organization is responsible for paying it unless it fits within one of the state’s specific exceptions. An organization that will sell goods must obtain a seller’s permit. Sales taxes can be required for a broad range of goods, including food sales, items sold for fundraisers, and auction sales. Exceptions are available for specific types of goods. For example, an organization can sell tickets to a show without collecting sales tax so long as the ticket price doesn’t include the cost of food or drinks.
  • Unrelated business income. A nonprofit that also runs a business that isn’t related to the charitable purpose for which tax-exempt status is conferred may need to pay what is called unrelated business income tax. A significant reason to pay close attention to the tax consequences of a business decision is to ensure that if it triggers unrelated business income the taxes are paid. Failing to do so may jeopardize the entire organization’s tax exemption.

Talk to an experienced nonprofit attorney about your tax plans

The Church Law Center of California assists clients in the secular and religious nonprofit communities organize and manage their organizations. We are available to answer your questions about how your organization’s plans may affect its tax compliance obligations. Call us today at (949) 689-0437 or reach out to us through our contact page.

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