How Taxation for Non-Profit Corporations Works

When it comes to non-profit corporations, most people think that they are exempted from paying taxes. However, this is not actually the case, and they have to pay taxes just like other operating businesses.

The only difference is that the taxes they pay differ, depending on the corporation’s status. Moreover, even if they are exempted from taxes, this doesn’t mean that they pay absolutely zero taxes.

With that said, this article will dive deeper into the mechanics of how non-profit corporations are taxed and further explain what non-profit corporations are and how they differ from for-profit business entities.  

 

What Is a Non-Profit Corporation?

A non-profit corporation is a business entity formed solely to serve the public good, such as charities, schools, churches, and others. The primary difference between non-profit corporations and for-profit businesses is that any revenue generated by a non-profit organization goes to paying bills and other aspects necessary to keep the corporation going.

Any leftover money will go back into the organization, which means everyone in the organization and the causes they support will benefit from the leftover profits. This is different from for-profit companies, where the business shareholders and owners receive the earnings from any generated income.

Although non-profit corporations don’t generally enjoy profits from the generated revenue, they enjoy several benefits as a business entity. For example, they can engage in other fundraising activities such as donations from the public and applying for and receiving grants to fund their cause.

Another common benefit of non-profit corporations is being exempted from paying taxes as stated by the US Internal Revenue Service (IRS) Code. However, as mentioned, tax exemption doesn’t mean paying zero tax. It just means that non-profit organizations are taxed differently than other business entities.

How Are Non-Profit Corporations Taxed?

As mentioned, non-profit corporations are generally tax-exempt, but this just means different taxation mechanisms rather than paying no tax at all. So, how does the government tax them?

There are two levels on which a non-profit organization can be taxed – federal and state.

1. Federal

Contrary to popular belief, non-profit organizations aren’t automatically exempt from taxes. However, they can apply for tax exemption according to the IRS Code 501(c)(3). This is the most common category given to non-profit corporations. Still, there can be slight variations to this, such as 501(c)(6).

The latter rule grants tax exemption for organizations like business leagues, chambers of commerce, real estate boards, etc. Meanwhile, the 501(c)(3) designation is given to non-profit organizations considered public charities, private operating foundations, or privately-owned foundations.

Your company’s articles of incorporation and bylaws should identify the corporation’s identity as a charitable organization to qualify for this category. Companies must also complete and submit the IRS Form 1023, which is a 30-page long application. 

Once you have submitted the necessary documents and the IRS accepts your application, your corporation is now considered non-profit and exempted from taxes. You will know this because the IRS will send a certificate of exemption that you should keep in your records and have copies of.

However, despite the tax exemption, the IRS will still require you to report your corporation’s income via IRS Form 990.

2. State

When it comes to state taxation, each one can decide on what exemptions it will offer businesses. Still, most states generally just follow what the IRS has decided upon. For your non-profit corporation to qualify for state-level tax exemptions, you need to apply again for each type of tax.

There are three major types of taxes – income, property, and sales taxes. Each one has different rules to follow, and these rules can vary from state to state. 

For example, for income tax exemptions, non-profit organizations must consult with their local state’s Department of Revenue to learn more about applying for tax exemptions in that particular state.

However, many states in the US, such as New Jersey, Arizona, and South Carolina, don’t require you to undergo another process. Presenting an IRS determination letter can serve as proof enough of your corporation’s tax-exempt status.

Nevertheless, suppose your non-profit corporation engages in activities that are unrelated to your cause. In that case, you will be required to pay income taxes on whatever revenue you generate from those activities. 

Real estate property taxes work the same way as income taxes for non-profit organizations. When you have tax-exempt status as a non-profit corporation, any property you own or use for charitable purposes is considered exempt from property taxes in the state.

On the other hand, you can enjoy tax exemption in two common ways when it comes to sales taxes. One is that your corporation won’t have to pay sales taxes on any products or services it purchases.

The other way is that any goods you sell as a non-profit corporation are exempt from being taxed by the government. Because there are two ways, you must research how the process works in your state of formation to avoid issues.

While the types of taxes mentioned above fall under the tax-exempt status, non-profit corporations still need to pay their employee taxes such as healthcare and social security, just like for-profit companies.

 

Why Non-Profits Enjoy Tax Exemption

Now that you know more about how non-profit companies are taxed, let’s dive deeper into the reasons for this exemption.

So, why do non-profits have the privilege of being exempted from paying taxes?

  • They benefit society.

Not only do they assist various groups and individuals that need it, but non-profit corporations also help build healthy communities by drawing attention to crucial issues in our society. 

Aside from this, they also encourage economic development to help the country’s further growth as time passes. Exempting them from paying taxes can help them use those resources to grow their cause further.

  • They assist the government and share some of the burdens.

Non-profits share some of the burdens the government has to shoulder by offering services that the government might be required to offer. By giving them a tax-exempted status, the government supports what the non-profits do by allowing them to use their sources to promote their cause further.

  • It would be counterproductive and even damaging to the community to tax non-profit corporations.

Not only is determining what can be taxed from non-profits difficult, but it can also be counterproductive because it would significantly impact how these corporations operate. Thus, it would cost the government more to tax them than to exempt them from paying taxes.

 

Final Thoughts

How taxation works for non-profit corporations can be a bit tricky to understand, especially since each state may have different regulations about how to conduct it. 

While most non-profit corporations are considered exempted from paying tax according to the IRS Code, it doesn’t mean that all of them are automatically exempt. You still need to research and find out if your state honors this exemption.

Nevertheless, hopefully, this article sheds some light on the mechanics of taxing non-profit corporations, and why they enjoy tax exemption in most areas.

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