What Is a 501(C)(3) Organization?

Section 501(c)(3) is a portion of the U.S. Internal Revenue Code (IRC) and a specific tax category for nonprofit organizations. Organizations that meet the requirements of Section 501(c)(3) are exempt from federal income tax. While the Internal Revenue Service (IRS) recognizes more than 30 types of nonprofit organizations, organizations that qualify as 501(c)(3) organizations are unique because donations to these organizations are tax-deductible for donors.

Key Takeaways

  • Section 501(c)(3) is a portion of the U.S. Internal Revenue Code (IRC) and a specific tax category for nonprofit organizations.
  • Organizations that meet the requirements of Section 501(c)(3) are exempt from federal income tax.
  • While the Internal Revenue Service (IRS) recognizes more than 30 types of nonprofit organizations, organizations that qualify as 501(c)(3) organizations are unique because donations to these organizations are tax-deductible for donors.

In general, there are three categories of organizations that may be eligible for the tax category outlined in Section 501(c)(3) of the IRC: charitable organizations, churches and religious organizations, and private foundations. The rules outlined in Section 501(c)(3) are regulated by the U.S. Department of Treasury through the Internal Revenue Service (IRS).

How a 501(c)(3) Organization Works

To be considered a charitable organization by the IRS, an organization must operate exclusively for one of these purposes: charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, and preventing cruelty to children or animals. Furthermore, the IRS defines "charitable" activities as relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.

In order to be tax-exempt under Section 501(c)(3), an organization must not be serving any private interests, including the interests of the creator, the creator's family, shareholders of the organization, other designated individuals, or other persons controlled by private interests. None of the net earnings of the organization can be used to benefit any private shareholder or individual; all earnings must be used solely for the advancement of its charitable cause.

It is also forbidden from using its activities to influence legislation in a substantial way, including participating in any campaign activities the support or deny any particular political candidate. It is typically not permitted to engage in lobbying (except in instances when its expenditures are below a certain amount).

People employed by the organization must be paid solely based on the fair market value that the job function requires, with no expectation of bonuses or compensation.

To remain tax-exempt under Section 501(c)(3), an organization is also required to remain true to its founding purpose. If an organization has previously reported to the IRS that its mission is to help less privileged individuals gain access to a college education, it must maintain this purpose. If it decides to engage in another calling鈥攆or example, sending relief to displaced families in poverty-stricken countries鈥攖he 501(c)(3) organization has to first notify the IRS of its change of operations in order to prevent the loss of its tax-exempt status.

While some unrelated business income is allowed for a 501(c)(3) organization, the tax-exempt charity may not receive substantial income from unrelated business operations. This means that the majority of the firm鈥檚 efforts must go towards its exempt purpose as a non-profit organization. Any unrelated business from sales of merchandise or rental properties must be limited.

While organizations that meet the requirements of Section 501(c)(3) are exempt from federal income tax, they are required to withhold federal income tax from their employees鈥 paychecks. There are some exceptions to this withholding rule; for example, if the employee earns less than $100 in a calendar year.

Special Considerations

Organizations that meet the requirements for the 501(c)(3) tax category can be classified into two categories: public charities and private foundations. The main distinction between these two categories is how they get their financial support.聽

A public charity is a nonprofit organization that receives a substantial portion of its income or revenue from the general public or the government. At least one-third of its income must be received from the donations of the general public (including individuals, corporations, and other nonprofit organizations).锘 If an individual makes a donation to an organization that is considered a public charity by the IRS, they may qualify for certain tax deductions as a donor that can help them lower their taxable income. Generally, donations to a tax-exempt, public charity under section 501(c)(3) are tax-deductible for an individual for up to 50% of their adjusted gross income (AGI).

A private foundation is typically held by an individual, family, or corporation, and obtains most of its income from a small group of donors. Private foundations are subject to stricter rules and regulations than public charities. All 501(c)(3) organizations are automatically classified as private foundations unless they can prove they meet the IRS standards to be considered a public charity. The deductibility of contributions to a private foundation is more limited than donations for a public charity.

To apply for tax-exempt status under section 501(c)(3), most nonprofit organizations are required to file Form 1023 or Form 1023-EZ within 27 months from their date of incorporation.锘 The charitable organization must include its article of incorporation and provide documents that prove that the organization is only operating for exempt purposes.

However, not all organizations that qualify for the tax category need to submit Form 1023. For example, public charities that earn less than $5,000 in revenue per year are exempt from filing this form. Even though it is not required, they may still choose to file the form to ensure that donations made to their organization will be tax-deductible for donors.