One of my favorite books and movies is “The Princess Bride.” There is a point when Princess Buttercup’s kidnappers realize that they are being followed that the group’s leader, Vizzini, yells “Inconceivable.” This becomes his response every time he is told that their pursuer is catching up with them. At one point Inigo Montoya, one of the kidnappers says of Vizzini’s use of “inconceivable” –“You keep using that word! I don’t think it means what you think it does.” The same can be the said of the phrases “tax exempt” and “non-profit.”
(I don’t want to get into too much detail. I could write a blog just on non-profits because of the complexity. I want to give readers enough info to get them thinking and researching.)
I want to specifically deal with tax exempt organizations because that is where I see the biggest problem. I talk to people all the time who are involved with a group they refer to as non-profit or tax exempt. They think by saying they are tax exempt means they don’t have to pay taxes. And if they don’t have to pay taxes they don’t have to file a tax return, right. No, that’s not right. A non-profit organization may still have certain taxes to report and pay. And even if they don’t have to pay Federal tax, they will have to file a return.
Let’s start with what is a tax-exempt organization (for IRS purposes)? It is usually a corporation (but it could be a trust or association) whose purpose meets very specific requirements outlined in IRS section 501(c). These entities are organized for charitable, civic/social welfare, labor/agriculture, business/profession, or social clubs. Most churches are also tax exempt but that is a whole separate post. While each group has a list of requirements to be met, the theory behind them is that they are designed to provide a benefit to part of the general public not to make a profit. If the organization meets these requirements, they do not pay federal income taxes on profits from the income of their main operation. But they do pay taxes.
Having tax exempt status does not mean you don’t pay taxes. The organization could still be subject to property taxes, sales tax on their sales, and payroll taxes for employees. And they could be subject to UBIT. Yes, even a tax exempt organization could pay federal taxes on some of their income because of unrelated business income. A quick example is in order. Bobville Community Theatre (BCT) is a valid 501 (c)(3). They pay property tax on the theatre and sales tax on the income from ticket sales and dues. And they match the Social Security and Medicare for their employee. In order to raise money, BCT creates a gift shop where they sell logo merchandise, memorabilia and treats to their patrons. The income from the gift shop is unrelated business income. It has nothing to do with why they have tax exempt status. That is why their tickets sales, dues and donations are not taxable. The gift shop isn’t part of their exempt purpose and if the income is over $1000, BCT must report it and pay taxes on it.
That brings us to the next big misconception – which is a tax exempt organization does not need to file a return. This was changed a few years ago and all organizations need to file one of the 990 series. Which one(s) depends on the amount of income they receive, if they have UBIT and several other factors. If the organization doesn’t file for 3 years, they are in danger of losing their tax exempt status. (Other posts- here and here
The only way to get tax exempt (non-profit) status is to apply through the IRS. The application may depend on the specific tax section you believe your organization falls under. But no matter which code section you think applies, you will have to provide lots of documentation. (And marking that you are a non-profit corporation on your state’s Secretary of State registration application does not make you a real non-profit and tax exempt.)
Look, there are a lot of meaning for the phrases non-profit and tax exempt. It depends on specific circumstances to know how taxes need to be handled. The biggest mistake a business can make is assuming that they are interchangeable. They aren’t. If you have some form of tax exempt status, make sure you understand exactly what limitations it has.
(FYI- of all the Federal tax exempt sections, only organizations which qualify for 501(c)(3) status (charitable) entitles a donor to a tax deduction in their tax return. But that's another post.)