What Is a 501(C)(3)?

What Does a 501(C)(3) Mean?

501(c)(3) stands for the section of the IRC (or Internal Revenue Code) devoted to the regulation of a special type of tax-exempt ventures. Moreover, it is the name given to organizations with such a status today. In other words, a 501(c)(3) establishment refers to trust, corporation, or another class of business, which meets the criteria of Section 501(c)(3). If the requirements are met, these companies are relieved of paying taxes and enjoy additional benefits when they receive donations.

Unlike typical business entities, non-profit companies do not aim at making profits for their owners. Such firms can have income, but they should not focus on making their owners richer. The mission of nonprofit businesses is often to advance a particular charitable cause. 

Managers or directors of a nonprofit organization may get paid. However, dividends or other similar funds are not distributed among the owners. All income is reinvested in the business.

The most widespread categories of charities are as follows:

• The Red Cross;
• Parent associations;
• Charitable hospitals;
• Nursing homes;
• The Salvation Army, etc.

Basic Types of 501(C)(3) Companies

The vast majority of 501(c)(3) entities belong to one of the following three categories:

Private Operating Foundations

It is a fairly rare kind of venture, which combines the features of a foundation and a public organization. This category includes any private foundation, which spends the bulk of its funds on active charitable programs.

We will show you two basic conditions under which an entity can be treated as a private operating foundation:

• 85% of base speculation return or balanced net gain is spent on tax-exempt business activities;
• Passing one of the tests below:

• The assets test;
• The support test;
• The endowment test.

Section 4942(j)(3) of the Internal Revenue Code states that individuals donating to a private operating foundation can qualify for a tax deduction. It is 50% of the donor’s adjusted gross income.

Private Foundations

It is likely that after receiving your application for obtaining 501(c)(3) business status, the IRS will treat your organization as a private foundation by default. Another common name for this organization is “non-operating foundation,” due to the lack of active programs. These foundations are not most often directly involved in philanthropy. Instead, they provide financial support to other public charities. As a rule, a private foundation allocates grants for this purpose, though it can use other methods as well. 

Private foundation businesses are usually supported by private donations. The contributor, in so doing, is entitled to a 30% tax deduction.

Section 509(a) of the IRC defines a private foundation as an organization other than a public charity. The most prevalent class of private foundation refers to a family foundation.

Public Charities

The legislature identifies such an organization as “not a private foundation”. Its operation is governed by sections 509(a)(0) through 509(a)(4) of the Internal Revenue Code. The objective of public charities should comply with one of the following options:

• Religious;
• Educational;
• Scientific;
• Prevention of cruelty to animals and children;
• Literary;
• Testing for public safety;
• Philanthropic;
• Fostering national or international amateur sports.

Public charities are known as the most common type of 501(c)(3) business ventures. They often develop active programs to directly realize their goals. The most widespread ones encompass animal welfare agencies, educational institutions, churches, etc.

This category of the tax-exempt company has to allocate a governing body to manage it. In general, it is made up of individuals independent of one another.

As for funding for public charities, the percentage of their sources is more than that of other 501(c)(3) businesses. At least a third of the funds for public charity usually comes from the state or the citizens. Support for such an entity is to be strong enough. Other sources of financing may include various agencies or other welfare organizations.

Similar to a private operating foundation and a “non-operating foundation,” donations to a public charity provide some advantages. The supporter may obtain a tax deduction of up to 60% of their revenue.

What About the Pros and Cons of a 501(C)(3) Venture?

Today, many companies strive for 501(c)(3) business status after appreciating the significant benefits it brings to the table. First and foremost, it is a tax exemption, of course. Such company owners should not worry about the following tax categories:

• Federal income tax;
• Property tax;
• Unemployment tax;
• Sales tax. 

Nonetheless, the unique status is retained by 501(c)(3) organizations only when all income is used for charitable purposes.

Besides, people donating to a 501(c)(3) company get some perks. The legislation allows them to deduct the amount of the contribution from their taxes, which can also be of interest to many private, as well as corporate, donors.

The goals of 501(c)(3) establishment often require serious financing, so they have the option of a public or private grant. A single condition is that the purpose and needs of the plan should be consistent with the grant.

Finally, 501(c)(3) organizations benefit from discounts on advertising, mailing services, and online apps.

The downside of being a tax-exempt company is you will probably face plenty of paperwork and financial audits. 

Furthermore, unlike some other business structures, when a 501(c)(3) organization closes, the owners will not get the remaining assets. Instead, the funds will go to charity. In fact, once created, such companies no longer belong to their owners but rather to the public.

How To Become Tax-Exempt?

When you are thinking about starting a 501(c)(3) company, following the statutory start-up process will play an important role. Generally, the following steps are needed to start a 501(c)(3) organization:

1. Define the purpose of the company and its operating procedures: Determine what kind of problems your venture will solve and the category of people it is aimed at. Think about potential employees, volunteers, or contributors;
2. Found a corporation: Choose the right name, prepare the documents, and create a board of directors. Submit formation paperwork to the state to make the company official;
3. File with the IRS: Use Form 1023 or 1023-EZ to register tax-exempt status. You are to give detailed information about your organization to complete the paperwork. As for the price to process the application, it can range from $275 to $600. If you are wondering how long you will have to wait, then it usually takes from 3 to 12 months for the IRS to make a decision and prepare a response;
4. Meet the current requirements: Unlike some other documents, such as licenses and permits, an organization with a 501(c)(3) status does not require annual renewal. Nevertheless, it is important to fully comply with all the legal requirements. The main ones include the following:

• Annual filing of Form 990 with the IRS. The data provided in this paper is public and includes such things as finances, management issues, directors, key personnel, and so on;
• Bookkeeping, including employee payrolls;
• Timely notification of a name or address change.

Requirements Needed to Get Tax-Exempt 501(C)(3) Status

Given their special status, the state keeps an eye on 501(c)(3) organizations. To retain their tax advantages, these companies have to comply with the statutory requirements, which include the following main points:

• Not to serve private interests;
• Profit-making activity is only allowed for charitable purposes;
• Net profit of the enterprise doesn’t have to provide any benefits to private shareholders or their relatives.