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Applying for Tax-Exempt Status

Federal Tax-Exempt Status

Section 501(c)(3) of the federal Internal Revenue Code provides income tax exemptions for charitable, religious, and other groups. The IRS Web site contains valuable information for charities seeking exempt status.  This section will highlight just a few important considerations.

It is important to carefully consider the definitions of the purposes that 501(c)(3) recognizes as exempt: charitable, religious, educational, scientific, literary, public safety, amateur sports, prevention of cruelty, and special issues.

The IRS carefully examines Articles and bylaws so it is important that they are complete and accurately state the organization’s exempt purpose. Although it is not required, the IRS will also look to see whether the organization has a conflict of interest policy that corresponds with the policy it recommends. (See Appendix A of the IRS instructions for a Sample Policy). 

Section 501(c)(3) groups are classified one of two ways, as private foundations or public charities. Most nonprofit corporations represented by law school legal clinics will fall into the latter category, so private foundations are not discussed here.

Completing the Federal Tax-exempt Application

Nonprofits seeking exemption from federal income taxes must fill out IRS Form 1023. This form, the instructions, and Publication 557 with more detailed information are available from the IRS website at no charge. The process is long, complex, and potentially costly. There also is a charge for filing—be sure to check with the IRS for the most current filing fees, which must be submitted with the application.  If possible, have the form reviewed by a tax attorney who specializes in nonprofit law before submitting it to the IRS

Accepting Donations While Waiting for IRS Exempt Status:  Fiscal Sponsors

The process of obtaining federal tax-exempt status can take quite some time, and many organizations want to start operating sooner.  During this “waiting period” the nonprofit cannot receive tax-exempt donations, and any donations individuals make during this time cannot be deducted as charitable contributions on their tax returns.  Therefore, the nonprofit may wish to explore using a “fiscal sponsor” to accept such donations. A fiscal sponsor is another entity that already has federal tax-exempt status, and which arranges to accept donations under its own name, then forward those donations to the nonexempt corporation. These fiscal sponsorship arrangements are extremely complex and if not set up carefully, can result in the “sponsor” losing its exempt status, the nonexempt corporation not receiving its exempt status, and donors not being able to claim a deduction on their tax returns.  Thus, it is imperative that a lawyer with expertise in nonprofit law review any such agreement to ensure that the agreement contains provisions giving the sponsor organization a certain amount of control over funds that are passed through to the nonexempt charity. 

Expediting the Exemption Application

On occasion, the IRS will expedite applications. To have an application expedited, a charitable organization must present a “compelling reason” which the IRS defines as follows:

-        A pending grant, where failure to secure the grant will have an adverse impact on the organization's ability to continue operating.

-        A newly created organization providing disaster relief to victims of emergencies.

-        IRS errors have caused undue delays in issuing a determination letter.

If the client decides to make a request, that request must be in writing, signed by a principal officer, and explain fully the compelling reason, including the following: the name of the organization or individual grantor, the amount of the grant, the date the grant will be forfeited, and a description of the adverse impact to the organization should the grant not be received. Usually, the IRS does not charge an additional amount for an expedited application, but that decision is solely within its discretion.

State Tax Exemptions

Usually a nonprofit that receives federal exemption status will not need to file separate state exemption requests, as long as they comply with all state and local rules. However, check with your state’s Department of Revenue to see if you need to formally request a state exempt organization tax number.

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