By: Jerri-Lynn Wier
Nonprofit organizations serve a diverse range of purposes and provide a wide range of services that support and strengthen communities. They also play a significant role in both state and local economies. Despite this significant impact, many misconceptions about nonprofits persist.
This article examines some common myths and misconceptions surrounding nonprofit organizations.
Myth 1: Nonprofit, tax exempt, and 501(c)(3) all mean the same
The terms “nonprofit,” “tax exempt,” and “501(c)(3)” are often confused, but they each mean something different.
- A nonprofit organization is typically a corporation established for a purpose that does not involve generating a profit. The entity is incorporated on the state level, not with the federal government.
- Tax exempt status means the organization is exempt from paying federal income tax, as outlined in the Internal Revenue Code.
- 501(c)(3) refers to a specific section of the U.S. Internal Revenue Code. This category includes nonprofit organizations recognized by the IRS as tax exempt due to their primary focus on religious, charitable, scientific, educational, or similar purposes.
Read: Are religious nonprofits tax exempt?
Myth 2: Nonprofits are automatically tax exempt
A nonprofit organization, whether it is a corporation or an unincorporated group, is not automatically exempt from federal or state taxes.
The federal rules for obtaining tax exempt status are stricter than those for being incorporated as a nonprofit corporation. As a result, some nonprofit corporations don’t qualify for federal income tax exemption; however, this is rare.
To become tax exempt, a nonprofit corporation must meet specific requirements and apply to both the IRS and the state.
However, churches that meet the criteria of IRC Section 501(c)(3) automatically qualify for tax exemption and do not need to apply to the IRS for this status. However, some income a church receives may still be taxable, such as income from unrelated business activities.
Unlike churches, other religious organizations usually need to apply to the IRS for tax exempt status unless their annual gross receipts are normally under $5,000.
Myth 3: There is no reason for churches to apply for tax exemption with the IRS
Many churches apply for tax exempt status from the IRS, even though it is not required. This status helps assure church leaders, members, and donors that the church is recognized as tax exempt and is eligible for certain benefits. For instance, individuals who donate to a tax exempt church can typically deduct their contributions on their tax returns.
A church may also struggle to get property tax exemptions on its land and buildings without an IRS determination letter. This letter confirms that the church's application for federal tax exemption has been approved.
If a church is part of a larger organization, it may want to check with that organization to see if it has a group ruling. If the larger organization holds a group ruling, the IRS may already recognize the church as tax exempt. With a group exemption, the parent organization is responsible for a ruling that identifies other connected churches or organizations. If a church appears on the list from the parent organization, it does not need to take any further steps to get tax exempt status.
The parent organization in a group ruling is listed by name in the IRS online search tool for tax exempt organizations. This tool helps individuals locate exempt organizations and verify their federal tax status and filings. However, the individual churches within that group may not be listed in this search tool.
Myth 4: All tax exempt nonprofits are 501(c)(3)
There are many different tax exempt classifications under Section 501(c) of the Internal Revenue Code.
It's essential for a nonprofit to accurately determine the correct tax exempt status based on its organization's primary objectives.
The most widely known classification is 501(c)(3).
Section 501(c)(3) outlines the purposes that qualify an organization for tax exempt status. These include charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports, and preventing cruelty to children or animals. Organizations that meet these criteria are referred to as charitable organizations.
Other popular classifications include
- 501(c)(4): Civic leagues, social welfare organizations, and local employee associations (e.g., housing associations, advocacy groups).
- 501(c)(5): Organizations related to labor, agriculture, and horticulture, such as farm bureaus and garden clubs.
- 501(c)(6): Business leagues, such as chambers of commerce and real estate boards.
Myth 5: A tax exempt nonprofit does not have to pay any taxes
An organization with tax exempt status does not have to pay federal corporate income tax on income generated from activities that are closely related to its purpose for which it was granted tax exempt status.
However, the organization is required to pay federal corporate income tax at standard rates on income that is unrelated to its tax exempt purposes, known as unrelated business income (UBI).
Additionally, nonprofits are subject to various other taxes, including federal payroll taxes (such as Medicare, Social Security, and unemployment taxes), state and local unemployment taxes, real estate taxes, personal property taxes, sales and use taxes, franchise taxes, and taxes on lobbying activities. Some nonprofit organizations may receive exemptions from specific state and local taxes based on their type or activities.
Myth 6: A nonprofit is not a business
A nonprofit is a type of business entity, such as a corporation or limited liability company (LLC), that is established through a state filing. While nonprofits are not focused on generating profit, they still engage in business activities and must comply with both state and federal laws that govern those activities.
For instance, nonprofits and for-profit corporations share similar governing policies. Both types of organizations should have written articles of incorporation, bylaws, and a set of governing policies that define the fiduciary duties and responsibilities of their boards of directors. Additionally, nonprofits must follow strict guidelines and are subject to regulatory oversight to ensure they operate within their designated charitable or educational purposes.
Myth 7: Nonprofits are organizations that are not designed to generate profits.
The term "nonprofit" can be misleading. Nonprofits can generate a profit. However, a nonprofit must aim to operate continuously, which means it may build reserves, demonstrate a net profit, and seek sufficient funds to ensure it can fulfill its mission in the long run.
The IRS tax code allows donors to claim a tax deduction for contributions to nonprofits, as these organizations provide public benefits. Essentially, the term “nonprofit” refers to a specific tax status.
The primary distinction between nonprofits and for-profits is that a nonprofit organization cannot distribute its profits to any private individual, although it can pay reasonable compensation to individuals providing services. In the for-profit sector, businesses raise capital from shareholders, who receive profits if the business is successful. In contrast, any profit generated by a nonprofit is reinvested in the organization and the social good it aims to achieve.
Myth 8: An effective nonprofit has minimal overhead
A common misconception in evaluating nonprofit effectiveness is the notion that the most effective organizations have minimal overhead. However, this mindset overlooks the fact that, to operate effectively and have a sustainable impact, nonprofits need to allocate funds to essential areas such as staff, technology, training, office space, and marketing.
Nonprofits are businesses, and to create long-term social change, they must have a stable financial base. Investing in salaries, technology, and well-planned fundraising efforts enables a nonprofit to make a greater impact.
Myth 9: Nonprofits are run entirely by volunteers
Nonprofits frequently rely on volunteers, but it is both common and practical to have paid staff. This paid workforce can include both regular employees and leaders, such as CEOs and executive directors.
When hiring any employee, a range of legal requirements must be addressed, including determining salary and benefits, filing a report with the state to document the hire, and calculating tax withholding from the employee's salary.
Myth 10: Nonprofits do not have to file an annual report
All states require some or all businesses, including nonprofits, to file an annual report. If the reports are filed late, there may be penalties.
These reports usually include the names and addresses of the nonprofit’s registered agent, directors, and managers.
Myth 11: Grant money is free money
Grants are a type of financial assistance provided by government agencies, corporations, foundations, and other organizations to support nonprofit organizations and their activities. To obtain a grant, organizations must compete for funding by submitting applications and undergoing an evaluation process.
Although grants do not need to be repaid, they are not free money. Funds must be spent responsibly and in accordance with the details outlined in the approved application.
Myth 12: The founder owns the nonprofit
Nonprofit organizations do not have owners or shareholders. Instead, they are managed by a board of directors that oversee the entity's operations.
Although individuals who establish nonprofits may wish to influence and manage their organizations, their personal control is typically limited. Nonprofit organizations must adhere to laws and regulations, including their own articles of incorporation and bylaws, which govern their activities and management.
Learn more
Vcorp can guide you through the process of incorporating your nonprofit. Contact Vcorp today for more information.
Related resources:
Application for Exemption
Nonprofit Formations
State Tax Exemption
Charitable Solicitation Registrations
