What is a nonprofit organization?
Generally, a nonprofit organization is a business entity that is formed under state law and not organized or operated to permit distribution of income, i.e., profit, to any individual or for-profit entity. State law definitions applicable to the range of nonprofit organization types vary, sometimes in subtle but significant ways.
For additional information about the laws and considerations applicable to the legal representation of nonprofits, see Freeman Law’s Representation of Texas Nonprofit Corporations.
Must a nonprofit distribute all its income annually so that it does not make a profit?
No. The term “nonprofit organization” is a little misleading. Despite the colloquial use of the word, most nonprofit organizations indeed desire to make a profit, that is, to receive and retain some amount of earnings for future use.
What business forms are available for nonprofit organizations?
A nonprofit organization may be formed as a charitable trust, a nonprofit corporation, an unincorporated association, or a limited liability company, provided that, for the latter, the member (and all members) meet certain qualifications.
Are all nonprofit organizations exempt from taxes?
No. “Tax exempt” generally means that the entity is, by some act of “legislative grace,” exempt from one or more categories of federal or state taxes. Not all nonprofit organizations are necessarily qualified to receive the benefit of all or even some exemption from a state or federal tax.
What is required to be exempt from a tax?
Exemptions from tax are a matter of legislative grace. Thus, in order to enjoy an exemption from a tax, a nonprofit organization must be organized and operated as required by the applicable state and federal statutes that afford an exemption from the applicable tax. And, most organizations are required to apply and receive approval for an applicable exemption from a tax.
On the federal income tax front, an organization described in subsection (c) or (d) of section 501 or section 401(a) of the Internal Revenue Code “shall be exempt from taxation” unless such exemption is denied under section 502 or 503 of the Code. Section 501(c) provides a 28-category list of organizations that may be exempt from taxation pursuant to section 501 or section 401(a) of the Internal Revenue Code. See 26 U.S.C. §§ 501(a), 501(c)(1)-(29) (28-category list), 501(d) (religious and apostolic organizations), 502 (feeder organizations), 503 (providing rules for denial of exemptions and for prohibited transactions).
But, the organization usually must apply and receive approval for the exemption. An organization may be formed as a nonprofit entity but also not be exempt from any tax for failure to apply for and receive governmental approval for the applicable exemption. For example, in order to enjoy an exemption from federal income taxes, a nonprofit organization must be organized and operated as required by the applicable state and federal statutes, and, with some exceptions, the nonprofit must apply for and receive a determination of exemption from the Internal Revenue Service. See 26 U.S.C. § 508(c) (excepting churches, integrated auxiliaries, and conventions or associations of churches from the requirement to file an application for exemption from federal income tax).
The form used for the application may depend on, among other things, the type of entity that is making the application and the amount of revenue that the entity expects to receive in the first years of operations. For example, nonprofit organizations that seek exemption from federal income tax under section 501(c)(3) of the Internal Revenue Code must apply to the IRS for the exemption through use of an IRS Form 1023 Application for Exemption or similar IRS-promulgated form. Nonprofit organizations that seek exemption from federal income tax under section 501(c)(6) of the Internal Revenue Code must apply to the IRS for the exemption through use of an IRS Form 1024 Application for Exemption or similar IRS-promulgated form.
For additional information about the organizational and operational requirements for exemption from federal income tax, see Freeman Law’s Representation of Texas Nonprofit Corporations and Freeman Law’s three-part series on Tax Exemption and Unrelated Business Income Tax (UBIT).
What are the most common types of organizations that are exempt from federal income tax?
Organizations formed pursuant to sections 501(c)(3) of the Code are the most prevalent form of organizations that are exempt from federal income tax. An entity that is tax-exempt pursuant to section 501(c)(3) is commonly referred to as a “public charity,” although other non-public charities—such as private foundations—may also be exempt from federal income taxes under section 501(c)(3).
To enjoy tax-exemption as an organization described in section 501(c)(3), the organization must be organized and operated exclusively for one or more of the purposes specified in section 501(c)(3). See 26 U.S.C. § 501(c)(3); 26 C.F.R. § 1.501(c)(3)-1(a)(1). An organization will be regarded as operated exclusively for one or more exempt purposes only if the organization engages primarily in activities that accomplish one or more of the exempt purposes specified in section 501(c)(3). See 26 C.F.R. § 1.501(c)(3)-1(c).
Another broad and common category of organization that is exempt from federal income taxes are trade associations, chambers of commerce, and other business leagues that are organized and operated pursuant to section 501(c)(6) of the Internal Revenue Code. Again, section 501(c) provides a 28-category list of organizations that may be exempt from federal income tax.
For additional information about the federal tax treatment of charitable contributions, see Freeman Law’s Joint Committee on Taxation Report on Tax Treatment of Charitable Contributions.
If a nonprofit is exempt from federal income tax, is the nonprofit also exempt from state taxes?
Not necessarily. Not all nonprofit organizations—even those that enjoy exemption from federal income tax under section 501(c)(3) of the Internal Revenue Code—are entitled to an exemption from state taxes. An exemption from federal income tax generally has nothing to do with an exemption from an applicable state tax. For example, an organization that is exempt from federal income tax must usually qualify, apply for, and receive approval from a state or local governmental agency for any available exemption from a state or local tax, including state property tax and state franchise tax.
Whether or not a nonprofit organization will qualify for such an exemption depends on the details of the exemption made possible by state or local legislative enactment and the form and substance of the application for exemption.
What laws apply to a nonprofit organization?
Nonprofit organizations are subject to internal rules and regulations (such as bylaws) and external rules and regulations (such as state and federal statutes and judicially created standards).
Under the internal affairs doctrine, the laws of the state of formation usually apply to the internal affairs of the nonprofit entity. Also, the organization’s internal rules and regulations, such as bylaws, provide the governance rules for the organization, provided that those rules are not contrary to applicable state law.
“Internal corporate affairs” are those matters which are peculiar to the relationships among or between the organization and its officers, directors, shareholders, and members. The internal affairs doctrine is a conflict of laws principle which recognizes that only one state should have the authority to regulate an organization’s internal affairs.
On the other hand, external affairs—such as employment matters, third party liability matters, recordkeeping requirements, and tax liability—are typically governed by federal law, the laws of the state in which the entity is domiciled or does business, where the incidents in issue occurred, or by choice of law contractual commitments.
As an example of state recordkeeping requirements for nonprofits, see Freeman Law’s Texas Nonprofit Corporations—Are these records open for inspection?. For a more global discussion of laws applicable to nonprofits, see Freeman Law’s Representation of Texas Nonprofit Corporations.
Do employment laws apply to nonprofit organizations?
Yes and no. State and federal employment laws generally apply to all forms of business entities, including nonprofit organizations. Thus, federal and state employment compensation withholding requirements, state and federal anti-discrimination laws, state prompt pay laws, the Fair Labor Standards Act, Family and Medical Leave Act, Americans with Disabilities Act, Equal Employment Opportunities Commission rules and regulations, Department of Labor rules and regulations, and other of the many state or federal employment statutes and regulations are generally applicable to even nonprofit organizations.
However, most employment laws do not apply to an employee who is a “minister” for employment law purposes, which is not the same as tax law purposes. See, e.g., Hosanna-Tabor Evangelical Lutheran Church & School v. EEOC, 565 U.S. 171 (2012) (adopting and applying the “ministerial exception” doctrine which provides, essentially, that secular courts lack subject matter jurisdiction to hear claims asserted by employees who are classified as ministers for employment law purposes); see also 26 C.F.R. § 1.1402(c)-5 (addressing tax matters for employees who may be ministers for tax law purposes).
Also, certain religious organizations may also enjoy statutory exemptions from certain secular anti-discrimination in employment laws. See and compare 42 U.S.C. § 2000e-2(a)(1) (prohibiting employment discrimination based on, among other things, religion), with 42 U.S.C. § 2000e-1(a) and 42 U.S.C. § 2000e-2(e) (providing certain exemptions from federal religious discrimination prohibitions for employers that are, for example, religious corporations and with respect to certain classifications of employees).
For additional information about the legal representation of nonprofit organizations, see Freeman Law’s Representation of Texas Nonprofit Corporations.
What are the responsibilities of officers and directors of a nonprofit organization?
Most nonprofit organizations have a board of directors, being the group of persons vested with the management of the affairs of the organization, regardless of the name used to designate the group. Some organizations coin their “board of directors” as a board of trustees, a board of elders, or other named governing body. And, the organization must or will usually have officers, such as a president, treasurer, and secretary, regardless of the name used to designate the particular office.
The individuals serving on a board of directors or as an officer are generally required to discharge their duties in good faith, with ordinary care, and in a manner the individual reasonably believes is in the best interest of the organization. Each state may have a statutory regime that prescribes the standards of conduct or duties owed by a director or officer. State statutes generally do not wholly replace common law (i.e., requirements established by courts) fiduciary duty concepts, such as the duty of care, the duty of loyalty, or the duty of obedience, each of which have similar but differing qualities.
“Ordinary care” basically means that the person exercises the degree of care that a person of ordinary prudence would exercise in the same or similar circumstances. If a director or an officer, for example, has special expertise in a particular matter, the ordinary care standard usually means that degree of care that a person with similar expertise would exercise in the same or similar circumstances. In executing the duty of care, the board of directors or officers may contract with and rely on experts, such as attorneys and tax consultants.
Common examples of breach (or potential breach) of these duties and standards of conduct include transactions that involve a conflict of interest and not properly presented and approved, usurpation of opportunity of the nonprofit organization, unauthorized disclosure of confidential information of the organization, and failure to abide by the internal rules and regulations of the organization.
For additional information and overview of director and officer fiduciary duties, see Freeman Law’s Fiduciary Duties of the Board of Directors in Texas and Representation of Texas Nonprofit Corporations.
Can a nonprofit engage in a trade or business and still maintain an exemption from tax?
The answer to this question depends on many factors, including the type of tax in issue, the type of organization, the type of trade or business in operation, and the type of income that the business generates for the nonprofit.
From a federal income tax perspective, please see Freeman Law’s three-part series on Tax Exemption and Unrelated Business Income Tax (UBIT). For an overview of Texas religious property tax exemption, see Freeman Law’s Texas Religious Organizations Property Tax Exemption.
