Preparing to File for Nonprofit Tax-Exemption

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At some point in the beginning stages of your new nonprofit, it will be necessary to turn to the task of completing IRS Form 1023 (or 1023-EZ) to obtain 501(c)(3) tax exempt status.   

IRS Form 1023 requires A LOT of information. Sigh...

So then why bother?

Well, first of all it gives your organization federal tax-exempt status. 

This means that your organization will not pay federal income tax on most of the income it receives.  So, for example, grants and contributions received will be tax-free.

Once exempt from federal income tax, the nonprofit will usually be exempt from similar state and local taxes.

On a practical side, having a tax-exempt determination means that you’ll be eligible to apply for foundation and other grants.  It also allows your donors to take a tax-deduction on their contributions. 

So, if your funding plan requires grants and contributions, obtaining tax-exempt status will be essential.

And yet, there is still all that paperwork to complete!

This guide is intended to take the surprise out of the process and give you a roadmap for the kind of information you’ll need to gather and provide to the IRS.

It doesn’t replace working with a qualified attorney or accountant. But it will give you an idea of what the process will look like.

The Narrative

First things first. You’re going to need to write a fairly detailed narrative summarizing your organization’s mission and activities.

This is the heart of your application and includes your organization’s past, present and future activities.  Here is where you tell the IRS about your organization’s programs.  

This part of the application is not about numbers, or dollars, or board of directors.  It’s about what your organization is going to do to carry out your mission.  

And if drafted correctly, the narrative should explain why your organization deserves tax-exempt 501c3 status.

So, what should you include in your narrative? 

You’ll  want to start with an introduction paragraph, describing when your organization was founded and in what state it’s incorporated.  

You’ll also want to include your mission or purpose. If your organization was formed to address a specific issue or problem, your description should orient the IRS to why your organization is needed.

Remember, your narrative is intended to explain to the IRS why your mission and activities are charitable, educational, scientific, religious, or otherwise exempt.

Next, you’ll describe each of your activities. If you have multiple activities, they can be broken into programmatic categories. 

For each activity or program, your narrative should answer the following questions:

What is the activity?   Who conducts the activity? When and where is the activity conducted?

How does the activity further your mission? 

What percentage of your time is allocated to that activity? 

How is the activity funded?

In drafting your activity descriptions, think action-oriented, including specific tasks and deadlines.  Each description should explain how the activity furthers your exempt purpose. 

In describing how much programmatic time will be spent on a specific activity, you’ll be using rough estimates as a new organization.  These best guesses should give the IRS an idea of which activities will engage most of your time, and which are minor programs. 

Be sure to count your volunteers’ time, as new organizations are often heavily reliant on volunteers.

In describing how each activity will be funded, you’ll need to be a bit aspirational about your fundraising plans, but try to stay realistic.  Funding may come from grants, donations, or charges for your goods or services.

If you charge for goods or services, you’ll need to explain how providing these goods or services is important to your tax-exempt purpose and noncommercial.  An example would be if you’re raising funds in order to provide the goods or service at below cost.  

Specific Activities

Lobbying

If you intend to influence legislation – that is, engage in lobbying – you’ll need to disclose this and be sure that your lobbying efforts are limited to what is permitted.  

Political Activity

Charities are prohibited from engaging in political activity. So, if you intend to engage in political campaign activity, 501c3 status will not be available.  

Bingo and Gaming

If you plan to offer bingos or other gaming activities, the IRS will scrutinize these activities because of past abuses.

Fundraising

You’ll need to attach a description of each type of fundraising activities your nonprofit will engage in. 

This may include mail solicitations, email solicitations, personal solicitations, vehicle or similar donations, foundation grants, phone solicitations, website donations, donations through another organization’s website and government grants.

The application also requires disclosure of any consultants who assist with fundraising. This could include grant writers, or fundraising consultants.  Note that fundraising consultants are heavily regulated due to abuses. 

Other

Form 1023 also requires additional information for specific types of organizations, such as those engaging in economic development, joint ventures, scholarship grants or foreign activity.  

Financial Data

Budgets

If your organization has been in existence less than 5 years when you apply for tax exemption, the budgets you submit will be a mixture of actual budgets and projections. 

If you file in your first year of existence, you’ll need to provide three years of financial information. If your organization existed for more than a year, the you’ll need to submit four years of financial information.  

In your budget, you’ll break out revenue and expenses.

Revenue includes gifts, grants, contributions; membership fees; investment income;  income from unrelated business activities; the value of free services or facilities provided by the government, and other types of revenue.

Expenses include fundraising expense; gifts, grants or contributions paid out; disbursements to members; officer/director compensation; staff salaries, compensation; professional fees; rent and utilities; interest expenses; depreciation; and other types of expenses.

Balance Sheet

You’re also required to submit a balance sheet as of the close of the last fiscal year. If you haven’t completed a fiscal year, then you use the most recent data.

Your balance sheet will show assets (cash, accounts receivables, etc.) and liabilities (accounts payable, etc.).

Public Charity Status

Organizations generally want to be classified as a “public charity” rather than a “private foundation”. Private foundations are subject to more stringent financial and recordkeeping requirements, as well as tax liabilities.

In order to be a “public charity”, you’ll need to prove that your organization is “publicly supported”, and not just supported by one funder or a limited number of contributions.

Typically, your organization can be a “public charity” if a substantial part of its support comes from the government or from contributions from the general public.   This would be shown in the income portion of your budget (see above). 

Alternatively, if one-third of your support is from contributions, membership fees, and gross receipts from your charitable activities, then your organization may be a “public charity”.

Conflicts of Interest

In various places throughout your application, you’ll be asked to disclose compensation and other arrangements with directors, officers, employees and other insiders.

The purpose of these questions is to ensure that your organization isn’t providing special benefits to insiders or engaging in transactions with insiders that create conflicts of interest.

Website

If you already have a website, there is a place on the form to list it. You don’t need to hurry up to get one. But if you do have a website, you should assume that the reviewing agent will review it as part of your application.

As you’re completing the form, keep in mind that your website and the information you submit to the IRS should be accurate and consistent.  

Getting your organization’s tax-exemption filing together is definitely a big task.  But it comes with big upsides.  

Your organization will be exempt from federal income tax (and likely state and local income taxes).  You’ll be eligible to apply for grants. Your donors will be able to deduct donations to your organization.

And if you file within 27 months of incorporating, your tax-exemption is retroactive to when you filed to incorporate.

It’s also helpful to view the application as an organizational planning process.  So, the end result is also a plan for your organization’s activities and funding, as well as budgets and projections for your organization’s initial few years.  

The information you gather through completing your tax-exemption application, together with your business plan, can really set you and your organization down the road to success.

Note: This website does not provide legal or tax advice and Nonprofit Springboard is not a law firm.