For most nonprofit organizations, tax exempt status is critical. In addition to avoiding federal corporate taxes and California franchise taxes, charitable tax-exempt status also allows donors to write off their donations on their own taxes. As a result, charitable nonprofits can more easily raise funds – and dedicate more of these monies towards their charitable purpose.

 

While tax exempt status is important, the process of obtaining it can be daunting. An application for 501(c)(3) status is difficult at best, particularly if you attempt to do it on your own. A seasoned California nonprofit attorney can help you with the process, from formation of your entity through getting federal and state approval of tax exempt status.

 

Daryl Reese Law advises and guides California nonprofit organizations on matters related to tax exempt status, governance, and more. As a former executive with more than 20 years of experience running nonprofits, Daryl Reese has both practical experience as well as in-depth legal knowledge of the nonprofit sector. Reach out to our law office today to learn more about how we can help your nonprofit organization.

Defining Your Organization’s Purpose

When starting a nonprofit, you will need to take a number of steps, from choosing a name for your entity to filing the articles of incorporation. One of the most important parts of this process involves crafting your purpose in your articles of incorporation. 


The Internal Revenue Service lists 29 different types of organizations that may qualify for tax-exempt status. To be eligible for 501(c)(3) status as a charitable organization, an entity must be organized and operated exclusively for exempt purposes set forth in section 501(c)(3) of the tax code (charitable, religious, scientific, literary, and/or educational purposes). 

 

When the IRS examines an organization’s application for tax exempt status, it will closely examine your articles of incorporation. In particular, the IRS will focus on the purpose clause. This section spells out the reason why your organization exists. 

 

The IRS is looking for three things: (1) to see if your organization is exclusively charitable; (2) that no part of the earnings will benefit an individual; and (3) that upon dissolution, the assets of the entity will not benefit an individual. In other words, the IRS wants to ensure that the entity has been created for the public good – not private benefit.

 

When you draft your articles of incorporation, you will want to make sure that you hit these three key points. The IRS provides sample language on its website for nonprofits and charitable organizations to use in their articles of incorporation. A CA nonprofit lawyer can help you hone this language as part of the drafting process, adding language for the specific purpose of the entity (i.e., ending animal cruelty or supporting at-risk youth in your community).

 

Once your articles of incorporation are complete, the language regarding the organization’s purpose can also be used in your bylaws. This checklist is an easy way to make sure that you do everything necessary to start your nonprofit, from obtaining an Employer Identification Number (EIN) to filing the necessary forms with the California Secretary of State.

Obtaining Your Federal Tax Exempt Status

California nonprofit organizations should start with getting tax exempt status from the IRS. Once you have this in hand, it is relatively easy to obtain tax exempt status from the California Franchise Tax Board.

 

Ideally, your organization should apply for tax exempt status within 27 months of the date that your articles of incorporation are filed. If you file within this time frame, then the tax exemption will take place on the date that your articles of incorporation were filed. As a result, any donations that you received from the point of incorporation forward will be tax-deductible. If you do not file within this time period and cannot show “reasonable cause” for the delay, then your tax exempt status will begin on the postmark date that you filed your application.

 

Nonprofit organizations must complete and file IRS Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. Smaller nonprofits may be able to file a streamlined version of this application, Form 1023-EZ. To qualify, your nonprofit must have less than $50,000 in annual receipts and $250,000 in total assets. The 1023-EZ is much shorter and easier to complete than the 1023.

 

If you must file Form 1023, then you will need to provide information about your entity, including its history, organization structure, governance policies, finances, operations, and activities. It is broken down into 11 parts as follows:

 

  1. Identification of Applicant: this section asks for information such as the name of the entity, contact information, date that the articles of incorporation were files, and the organization’s EIN.
  2. Organizational Structure: in this section, you will need to attach a copy of your articles of incorporation and bylaws. As noted above, you must have a clause that states that your organization was formed for a recognized 501(c)(3) tax exempt purpose and that any assets of the nonprofit that remain after dissolution will be distributed to another nonprofit or government agency for a public purpose.
  3. Narrative Description: here, you will provide a detailed description of what your organization does and what it plans to do. For each activity, you will need to describe how it furthers an exempt purpose, the percentage of time devoted to the activity, when it started or will start, where it will be conducted, who will conduct it, and how it will be funded.
  4. Compensation and Financial Arrangements: in this section, you will provide information that demonstrates that the nonprofit will not be operated for private benefit. You will need to detail all proposed compensation to and financial arrangements with the entities’ leaders (officers, directors, and/or trustees) and the five top-paid employees and independent contractors who will earn more than $50,000 annually. Compensation amounts should include associated benefits. This section also contains questions about potential conflicts of interest.
  5. Beneficiaries of the Nonprofit: if your nonprofit will provide goods or services, then you must describe who will benefit from these activities (such as people who are victims or survivors of domestic violence).
  6. History of the Organization: this section is only applicable to entities that are successors to incorporated or preexisting organizations.
  7. Details on Specific Activities: the tax code prohibits 501(c)(3) organizations from engaging in certain activities, such as lobbying and electioneering. This section asks about these forbidden activities.
  8. Financial Data: in this section, you must provide a statement of revenues and expenses and a balance sheet. The amount of financial data that you will need to provide will be based on how long your organization has been in existence.
  9. Type of Organization: here, you will need to state whether your organization is a public charity or a private foundation. Most nonprofits prefer to be classified as a public charity, which receives most of its funding from the public or activities related to its tax exempt purposes. Under IRS regulations, all new 501(c)(3) groups are automatically classified as public charities for the first 5 years of their existence as long as they indicate on Form 1023 that they reasonably expect to receive qualifying public support. After 5 years, the IRS will then monitor the organization to ensure that it receives the necessary public support to continue to qualify.
  10. Fee Information: you must pay a fee to submit Form 1023 or Form 1023-EZ. The current fees are $600 for Form 1023 and $275 for Form 1023-EZ.
  11. Additional Schedules: some entities must submit an additional schedule based on the type of organization involved, when they are filing Form 1023, or if they are a successor to another nonprofit. 

 

Once you have completed the form, you must file and submit it to the IRS. The IRS will acknowledge receipt of your application and begin processing it. In some cases, the application will be assigned to an Exempt Organization Specialist, who may request further information from your nonprofit.

 

The IRS will either grant your federal tax exemption or deny it in a determination letter. A denial becomes effective 30 days after it is issued. If you receive a proposed denial of tax exempt status, you should contact a seasoned California nonprofit attorney immediately. Otherwise, you can use your new federal tax exempt status to apply for tax exempt status in California – and to start soliciting donations from supporters.

 

Apply for Tax Exempt Status in California

Once you have your federal tax exemption, you can file an application for tax exempt status from the California Franchise Tax Board (FTB). With federal tax exempt status, you will need to file Form 3500A and attach a copy of your determination letter from the IRS. Form 3500A is a relatively simple 2 page form.

 

If you do not have a federal tax exemption, then you will need to file Form 3500, which is available upon request from the FTB. This form is much lengthier – 20 pages – and asks for much of the same information that is required in IRS Form 1023.  Because Form 3500A is much easier to complete, most nonprofit organizations apply for and receive federal tax exempt status before applying for state tax exempt status.  

 

There are a number of benefits to obtaining tax exempt status in California. This includes an exemption from certain sales and use taxes, potential exemption from state property tax, and an exemption from state income tax. A California nonprofit attorney can help you file for and obtain both federal and state tax exemptions.

Maintaining Tax Exempt Status

Tax exempt status is incredibly important to nonprofit organizations. Without this status, nonprofit organizations will be required to pay state and federal corporate income taxes. It can also be hard to obtain donations and other forms of support, such as grants, if you lose tax exempt status.

 

It is possible to have your federal and state tax exempt status revoked. Primarily, this occurs when a nonprofit fails to file tax returns. The IRS will automatically revoke an organization’s exemption if they do not file a tax return for 3 consecutive years. It may also revoke a nonprofit’s exempt status if they engage in forbidden activities, such as operating outside of its stated purpose.

 

The FTB will typically revoke a nonprofit’s exempt status if the IRS issues a revocation. It may also revoke an entity’s status for failure to file a return, failure to pay a balance due, or for being suspended by the Attorney General’s Registry of Charitable Trusts.

 

Because of the importance of tax exempt status, it is vital that nonprofits fulfill their registration, reporting, and tax obligations. A nonprofit attorney can ensure that your organization is in compliance with all applicable state and federal requirements.

How Our Law Firm Can Help

Being tax exempt is everything to a nonprofit organization. Without tax exemption, it may be difficult – or even impossible – to fulfill your charitable purpose. While obtaining tax exempt status can be challenging, it is necessary to the operation of every nonprofit organization.

 

Daryl Reese Law counsels nonprofit organizations throughout California on formation, governance, tax exemption, and other issues. With decades of experience in the nonprofit world, we understand both the business and the legal aspects of running a successful nonprofit. To learn more or to schedule a consultation with a California nonprofit lawyer, give us a call at (707) 858-5000 or fill out our online contact form.

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