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Tuesday, September 27, 2011

“Non-Profit” Does Not Equal “Tax-Exempt”: Applying for Federal Tax-Exempt Status

Many individuals who start a “non-profit” organization incorrectly assume that setting up a “non-profit” entity (i.e. a “non-stock corporation” in Virginia) will automatically make that entity exempt from federal, state and local taxes, and will permit donors to take a charitable deduction on their individual tax statements. A full discussion of tax law applicable to non-profit organization is beyond the scope of this article. However, we want to impart some general knowledge regarding how to set up a non-profit organization in Virginia and some general information regarding applying for tax-exempt status with the Internal Revenue Service.

In Virginia, a non-profit organization is usually a non-stock corporation, which is a form of entity that does not issue stock and is governed by the by-laws adopted by the members of the organization. There are many ways to organize the governance of the corporation, but generally, it is run by a board of directors that is elected by members of the organization. How a person becomes a member of the organization is determined in accordance with the rules set out in the by-laws. Of course, the members or the board of directors can elect a CEO or President to run the day to day operations of the organization.   
Becoming a non-profit entity under Virginia state law permits certain exemption from various state and local taxes, but does not automatically result in exemption from federal income tax. The first step to gaining federal tax-exempt status is to determine which type of tax-exempt organization the entity is. The most common categories of tax-exempt entities are: (1) Charitable and religious organizations; (2) Business leagues; (3) Labor organizations; (4) Social welfare organizations; and (5) Agricultural/horticultural organizations. The two most common types of tax-exempt organizations that Gross & Romanick helps to establish are charitable/religious organizations and business leagues.


Charitable and religious organizations must apply for tax exemption under Internal Revenue Code Section 501(c)(3) by filing a Form 1023. In order to qualify for tax exemption under Section 501(c)(3), the organization must be organized and operated exclusively for religious, educational, scientific, or other charitable purposes, the net earnings may not inure to the benefit of any private individual or shareholder, no substantial part of its activity may be attempting to influence legislation, the organization may not intervene in political campaigns, and the organization’s purposes and activities may not be illegal or violate fundamental public policy. A 501(c)(3) organization must benefit the public, and it activities must be limited to a specified cause. A 501(c)(3) organization is eligible to receive grants but cannot engage in political lobbying. Donations to a 501(c)(3) organization are generally tax deductible as charitable contributions.

Business leagues must apply for tax exemption under Internal Revenue Code Section 501(c)(6) by filing a Form 1024. A business league is an association of persons having some common business interest, the purpose of which is to promote such common interest and not to engage in a regular business of a kind ordinarily carried on for profit. In order to qualify for a tax exemption, a business league's activities must be devoted to improving business conditions of one or more lines of business, as distinguished from performing particular services for individual persons. No part of a business league’s net earnings may inure to the benefit of any private shareholder or individual, and it may not be organized for profit to engage in an activity ordinarily carried on for profit. Business leagues, unlike 501(c)(3) organizations, are not eligible for grants, but may engage in political lobbying. Membership dues to a 501(c)(6) business league are not tax deductible, but can be classified as a business expense. 

Both the Form 1023 and the Form 1024 are lengthy application packets which require the applicant to supply the IRS with a substantial amount of business and financial information. The IRS carefully reviews the applications to ensure that the applicant strictly complies with the statutory requirements. For many organizations, the assistance of an attorney in the preparation of the tax-exemption application may be necessary. 

The attorneys at Gross & Romanick, P.C. have substantial experience representing non-profit organizations throughout the process of establishing the non-profit entity and applying for tax-exempt status. Gross & Romanick is general counsel for non-profit organizations, assisting with various issues including leases, property tax assessments, employment law and other legal matters.