The terms nonprofit and tax-exempt are often conflated. Many people in the nonprofit world use the terms interchangeably because it is so common for nonprofits to be tax-exempt. However, the terms “nonprofit” and “tax-exempt organization” are distinct. A nonprofit is a corporate status under state law while tax-exemption is a status under federal tax law. Tax-exempt status is granted to organizations which follow a set of criteria including limiting their authority to engage exclusively in charitable activities. Accordingly, nonprofits make the choice to become tax-exempt.
What Does it Mean to be a Taxable Nonprofit?
Taxable nonprofits are those entities that are organized as nonprofit entities but do not elect to become tax-exempt. Similar to a C-corporation or other taxable entity, taxable nonprofits’ income will be taxed at the normal corporate rates. These organizations will have to file annual corporate tax returns, may take advantage of tax credits and deductions, and may have tax liability due at the end of their fiscal year. The taxable nonprofit acts similarly to a tax-exempt organization but does not have to restrict its purposes and activities to those which are exclusively charitable. In this sense, taxable nonprofits have greater flexibility and freedom in how they operate.
Why Would a Nonprofit Choose to be Taxed?
A nonprofit may choose not to be tax-exempt for many reasons. For example, the organization might want to meet some regulatory requirement that requires the entity to be a nonprofit but does not require it to be exempt. Another common scenario is a group that needs an entity to direct a joint effort and pool funds for an activity that does not qualify for tax-exemption. The alternative is for a one or more individuals or an entity owned by individuals to hold the funds which can lead to mistrust among the group, complicate the holder’s own tax reporting, and even lead to personal tax liability.
How Are Taxable Nonprofits Different from Tax-Exempt Charities?
Tax-exempt charities must follow strict rules which often do not align with for-profit principles and practices. For example, tax-exempt organizations must exclusively pursue tax-exempt purposes and commit their assets to those purposes in perpetuity. They are forbidden from operating in an overly commercial manner similar to for-profits, and cannot pay profits to insiders without jeopardizing their tax-exempt status and subjecting themselves to penalties. Additionally, tax-exempt organizations are limited to paying “reasonable compensation.” In contrast, a taxable nonprofit can operate as a board or member driven entity for governance purposes without having to limit its activities, forgo distributions, limit compensation, or permanently dedicate the entity’s assets.
Although nonprofits almost always choose to seek tax-exempt status, there are some cases where a taxable nonprofit makes sense. Each nonprofit must weigh the costs and benefits of tax-exemption to determine which structure best fits their needs. Remember to consult an attorney or tax professional who will be able to advise on the rules applicable to tax-exempt organizations so that your nonprofit will stay compliant with the law.
Kyler Mejia is an attorney with Caritas Law Group, P.C.. Kyler advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations nationwide as well as donors with regard to major gifts. To schedule a consultation, call 602-456-0071 or email us through our contact form.