- Nonprofit organizations are exempt from federal income taxes and must not be seeking commercial or monetary profit.
- Nonprofits are liable for payroll taxes and Social Security and Medicare contributions.
- To retain tax-exempt status, nonprofits must annually submit a detailed summary of business activities.
- This article is for nonprofit leaders looking for more details on their specific tax liabilities.
So you have a great idea for a nonprofit organization that seeks to bring goods and resources to an underserved area in our society, but you don't know where to start. How do you incorporate as a nonprofit? What does tax-exempt really mean? Does a nonprofit have any payroll tax liabilities?
In this article, we'll explore the unique challenges of and implications regarding filing as a tax-exempt organization and ways to ensure your organization remains compliant.
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What is a nonprofit organization?
Public-serving organizations have been operating in the United States since the beginning of the republic. However, the modern U.S. tax-exempt structure developed recently, within a 75-year period ranging from 1894 to 1969. This federal tax exemption is seen as a way for the U.S. government to recognize the important work of charitable organizations as part of American communities.
The most common nonprofit is classified as a 501(c)(3), defined by the IRS as an entity "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, educational, or other specified purposes."
Tax-exempt organizations must also not be seeking commercial or monetary profit by promoting private interests. Individuals or stakeholders cannot benefit from any net earnings. That's not to say nonprofits cannot make money; additional funds simply must go back into the organization or toward the organization's purpose.
There are also less common tax-exempt classifications, including:
- 501(c)(4): Social welfare organizations
- 501(a): Other nonprofit organizations
All three classifications are considered tax-exempt, meaning qualifying organizations are not liable for federal income taxes on any net profit they might generate.
How to file as a nonprofit organization
To declare your organization as a nonprofit, you must first find which tax-exempt classification your organization falls under and apply for tax-exempt status through the IRS website.
If you were to determine your organization falls under the most common 501(c)(3) tax-exempt classification, you would need to fill out Form 1023 on the IRS website and request an employer identification number, even if you do not yet have employees.
Are nonprofits liable for any taxes?
The term "tax-exempt" means qualifying organizations do not have to pay federal income taxes. They are still liable for a number of taxes, however, including payroll, unrelated business income, and certain state and local taxes.
Tax-exempt organizations are still subject to payroll taxes. Much like commercial businesses, nonprofit organizations must pay the Federal Insurance Contributions Act (FICA) tax by withholding federal income taxes and Social Security and Medicare from employees' paychecks. The organization must also match an employee's Social Security and Medicare contributions.
Unlike for-profit businesses, a 501(c)(3) organization is not liable for Federal Unemployment Tax Act (FUTA) taxes. This is not the case for all tax-exempt classifications, however. Nonprofit organizations not classified as 501(c)(3)s are still liable for FUTA taxes.
The nonprofit organization may be liable for any state and local taxes, such as State Unemployment Tax Act (SUTA) taxes. While there are some exceptions on payroll taxes for charitable organizations, it's best to check the specific tax requirements in your city and state as these can vary widely.
Key takeaway: Nonprofits must still withhold FICA taxes – which include federal income taxes, Social Security and Medicare – from an employee's paycheck. Nonprofits classified as 501(c)(3) are not liable for FUTA taxes; however, they may be liable for specific SUTA taxes.
Nonprofits have the added benefit of attracting volunteers to aid their missions. Nonprofits often reward volunteers for their time; however, it is important that these rewards are not taxable. If taxable gifts are given in exchange for a volunteer's work, the organization must withhold taxes as they do with payroll, and the volunteer must report the value as taxable income.
Grants to cover payroll costs
Nonprofits often apply for grants from foundations or for-profit organizations as a source of funding. These grants are typically for a specific project that furthers the organization's greater mission. Depending on the terms of the grant, these funds can cover certain payroll costs associated with an employee or employees whose work primarily supports the specific project.
It is important to note that employees who are funded by a grant will need to meticulously track their time back to the grant, particularly if their time is split between multiple projects. Administrators will need to report these expenses back to the grantor.
Unrelated business income
Nonprofits may also be liable for tax on any unrelated business income that is not significantly related to the charitable or educational purpose of the organization. An unrelated business is considered selling goods or services for the purpose of generating income.
If gross earnings from an unrelated business exceed $1,000, the organization must file a Form 990-T and pay an estimated tax for the year if the expected tax is $500 or more.
How to retain tax-exempt status
To keep their federal and state tax-exempt status, nonprofits must comply with strict guidelines and file IRS forms each year, depending on their specific tax-exempt classification, gross receipts and total assets.
|Form 990||Exempt organizations with gross receipts greater than or equal to $200,000 or total assets greater than or equal to $500,000 by the end of the tax year|
|Form 990-EZ||A short version of Form 990|
|Form 990-N||Exempt organizations with gross receipts less than or equal to $50,000; submitted electronically only|
|Form 990-PF||Exempt and taxable private foundations, including nonexempt charitable trusts; no gross receipt limit|
|Form 990-T||Used by nonprofits to report unrelated business income|
|Form 990-W||Used by nonprofits to report estimated tax on unrelated business income|
This annual form is a detailed summary of your organization's business activities including revenues, expenses, assets and liabilities. These forms are intended to hold organizations accountable and to confirm all earning and spending aligns with the organization's stated mission.
These forms are made public, so it is important that expenditures and business-related income are accurately claimed and reported.
How can you lose tax-exempt status?
It is incredibly important for a nonprofit to file a Form 990 every year to ensure that it retains its tax-exempt status and good public standing. If an organization fails to file the correct forms for three consecutive years, it will automatically lose its tax-exempt status and will be published on the IRS' automatic revocation of exemption list. This list includes an organization's primary details and effective date of revocation.
If revoked, the organization is subject to federal income taxes and will no longer be eligible for tax-deductible donations.
Tip: Keep detailed financial records and be aware of the legal tax deductions you can make on your annual Form 990 to ensure your nonprofit retains its tax-exempt status and is in good standing.
Managing your nonprofit's taxes
While an IRS tax-exempt classification allows an organization to avoid some federal income taxes, there are still a number of tax considerations when filing and strict guidelines to follow in order to retain tax-exempt status.
Much like any small business or for-profit entity, a nonprofit's tax filing and payroll can be a headache. Nonprofits typically have the added issue of limited funding and a small staff that may already be performing multiple responsibilities. Tax-exempt compliance is complicated and could be putting your organization at risk if not done correctly.
Here are some tips that might assist with your nonprofit's administrative needs:
- Hiring an accountant or a professional tax service might be helpful to your organization to ensure ongoing tax compliance and retain tax-exempt status with the IRS.
- If you have employees, consider choosing a payroll service that works best with your nonprofit's specific needs. These third-party services ensure tax compliance and payroll processing along with other features. Payroll service pricing typically includes both a flat monthly fee and a per-employee fee. Check out our review of Paychex, one of our best picks for payroll services in 2021.
Understanding the ins and outs of tax-exempt status is vital to any nonprofit's activities, operational practices and fundraising. Consider investing in professional tax services or payroll processing services to allow your organization to focus on better serving the community.