A nonprofit’s tax-exempt status refers to a number of tax privileges provided by federal and state law. By far the most important 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. The state has its own processes for granting nonprofits tax-exempt status that must be complied with separately. Failing to do so could expose the organization to state income tax, even though it is exempt from paying federal income taxes.
In addition, nonprofits must follow certain rules and abide by certain prohibitions in order to retain their tax-exempt status:
501(c)(3) nonprofit corporations are prohibited from direct or indirect participation in political campaigns. According to the IRS, nonprofits organized as a 501(c)(3) are “absolutely prohibited” from political activities, including “directly or indirectly participating in, or intervening in, any political campaign.” Nonprofits organized under 501(c)(3) also cannot contribute to campaigns or provide any verbal or written position statements.
Nonprofit corporations are prohibited from having a substantial part of their activity devoted to political lobbying. To determine what constitutes a “substantial part,” the IRS uses a “facts and circumstances” test that takes a number of factors into consideration, including the amount of time and money devoted to lobbying (the “substantial part” test). Nonprofits may opt out of the substantial part test and instead elect the “expenditure test,” which details the level of lobbying expenses permitted by the IRS as calculated using the nonprofit’s exempt purpose expenditures.
Nonprofit corporations are prohibited from distributing profits to directors, officers, or members. Nonprofits cannot be formed for the financial benefit of their directors, officers, or members.
Nonprofit corporations are required to pay taxes on “unrelated business income.” The IRS has three requirements for whether revenue is treated as unrelated business income: (1) it is a trade or business; (2) it is regularly carried on; and (3) it is not substantially related to furthering the exempt purpose of the organization.
Nonprofit corporations are prohibited from making substantial profits from unrelated activities. Nonprofits can create for-profit subsidiaries to carry out the income-generating activities they undertake. However, if these generate substantial profits, the nonprofit’s tax-exempt status could be jeopardized. The law in this area is very complex, and should only be considered with the advice of counsel experienced in nonprofit law.
When a nonprofit corporation is dissolved, its assets must be distributed to another tax-exempt entity. A nonprofit’s assets cannot be owned, so they can never be sold. If a nonprofit is dissolved, any remaining assets must be donated to another nonprofit.
The Church Law Center of California assists nonprofits with organization, governance, and risk management. We can help your nonprofit craft policies so it is in a better position to address problems as they arise. To find out how we can help your nonprofit, call us today at (949) 245-3177 or reach out to us through our contact page.