“Not all tax-exempt organizations offer the donor deduction benefit. For example, social welfare groups (501(c)(4)) and trade associations (501(c)(6)) are tax-exempt, but donations to them are usually not deductible for the donor.”
Charitable groups, also called nonprofits, work to fix problems in our communities, from helping the poor to protecting nature, and they get a special break from the government called a tax exemption. This means they don’t have to pay certain taxes, allowing them to spend more money on their actual mission.
But getting this status isn’t automatic or simple. In the U.S., it’s mostly overseen by the Internal Revenue Service (IRS) and involves following a strict set of rules.
What Tax Exemption Means
Simply put, when an organization is “tax-exempt,” it doesn’t have to pay federal income tax on the money it makes from activities directly related to its purpose.
To get this, an organization has to apply and be officially recognized. The most common type is called 501(c)(3). This status is reserved for organizations that are strictly religious, charitable, educational, scientific, or for public safety.
What You Need To Know
- You Must Apply: The status is not granted automatically. You have to formally apply, usually using IRS Form 1023.
- It’s About the Purpose: The tax break is given because of what the organization does, its mission. 501(c)(3) is the most popular for charities.
- The Donor Benefit: The best part of the 501(c)(3) status is that people who donate money to the organization can usually deduct that gift from their own taxable income.
- Rules for Life: To keep the status, nonprofits must constantly follow rules about how they operate, what information they make public, and how they report their finances every year (on Form 990).
Tax Exemption vs. Donor Deduction: Two Different Things
It’s easy to confuse these two, but they are separate:
| Who it Applies To | What it Means | |
| Tax Exemption | The Nonprofit Organization | The organization itself doesn’t pay income tax on its qualified activities. |
| Tax Deductibility | The Donor | The person giving the money can use that donation to reduce their own taxes. |
It is important to note that not all tax-exempt organizations offer the donor deduction benefit. For example, social welfare groups (501(c)(4)) and trade associations (501(c)(6)) are tax-exempt, but donations to them are usually not deductible for the donor.
The Two Tests For 501(c)(3) Status
To qualify for 501(c)(3) status, a nonprofit must pass two main tests:
1. The Structure Test (Organizational Test)
The organization’s paperwork and founding documents, like the Articles of Incorporation, must state two things:
- Limited Purpose: The organization’s purpose must be tied to one of the IRS-approved goals, like charitable or educational goals.
- Asset Rule: If the organization ever shuts down, its assets must go to another 501(c)(3) charity, ensuring the money continues to serve the public.
2. The Activity Test (Operational Test)
This is about what the organization actually does. The nonprofit must operate almost entirely for its exempt purpose, within the bounds of these two major restrictions:
- No Private Profit: This is the most crucial rule. The organization cannot be run to make money for its founders, board members, or key employees beyond paying them a reasonable salary for their work. The organization’s main goal must be to serve the public, not private individuals. Breaking this rule can mean losing tax-exempt status.
- Limits on Politics:
- Political Campaigns: The organization is completely banned from supporting or opposing any candidate running for public office. Violating this means immediate loss of status.
- Lobbying: The group can try to influence laws (lobbying), but this activity cannot be a “substantial part” of what they do.
The Unrelated Business Income Tax (UBIT)
Tax exemption is not a free pass on all taxes. Nonprofits still have to pay tax on income from an activity that is:
- A business or trade.
- Carried on regularly.
- Not substantially related to the organization’s main charitable mission.
Why UBIT? It’s to keep things fair. If a nonprofit starts running a regular business that doesn’t relate to its mission, that income is taxed, so they don’t have an unfair advantage over for-profit companies.
For example, a museum’s mission is education, and it is not taxed on its gift shop selling art reproductions, since such an activity is related to education. However, running a public, seven-day-a-week parking garage that anyone can use is not related to the mission, so that income is likely subject to UBIT and will be taxed.
The Bottom Line: Transparency Through Form 990
To keep their tax-exempt status, most nonprofits must file an annual financial report with the IRS called Form 990. This form is vital because it ensures the organization is accountable to the public:
- It details the organization’s income, spending, and assets.
- It asks about the board and management (governance).
- It requires the organization to explain its program accomplishments and how it spent money to achieve its mission.
Crucially, Form 990s are public. Donors and the general public can look up the last three years of a charity’s 990 to see its financial health and how well it is managed.
In short, the tax exemption is a huge privilege, and in return for that benefit, nonprofits must operate with integrity, keep their focus on the public good, and be transparent about their finances. The 501(c)(3) status is a mark of legitimacy that helps them raise the money they need to do their important work.
Benzinga Disclaimer: This article is from an unpaid external contributor. It does not represent Benzinga’s reporting and has not been edited for content or accuracy.
