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Requirements to Become an IRS 501(c)(3) Tax-Exempt Organization

The IRS provides certain nonprofit organizations the opportunity to apply for tax-exemption under section 501(c) of the Internal Revenue Code. There are 26 different types of nonprofits covered in the 501(c) classification, but the most commonly applied is subsection (3), which covers religious, educational, charitable, scientific, literary, testing for public safety, to foster national or international amateur sports competition, or prevention of cruelty to children or animals organizations. There are five important factors, or tests, that an organization must adhere to in order to qualify under section 501(c)(3). These five factors are:

Organizational Test

The stated purpose of the nonprofit organization must be exclusively for one or more of the exempt purposes described in section 501(c)(3). The purpose must be included in the nonprofit's governing documents (such as the Articles of Incorporation) with the correct wording to meet certain IRS requirements. The two primary concerns for passing the organizational test is that the purpose be clearly limited to the options within the 501(c)(3) section and that the assets of the organization are irrevocably dedicated to one or more exempt purposes.

Operational Test

The actual operations of the organization must be primarily dedicated to the stated exempt purposes. Although the regulation uses the term exclusive, in that the organization must be operated exclusively for one or more of the exempt purposes set forth in section 501(c)(3), in fact the organization can allow an "insubstantial part" of its activities to be geared to non-exempt purposes, such as operating an unrelated business. However, the profits from that unrelated, non-exempt purpose may be subject to business taxes. But from a standpoint of qualifying for 501(c)(3) status, the organization should be operated primarily for the stated exempt purposes.

No Private Inurement

Private inurement occurs when an individual who has a good bit of influence over an organization receives benefits greater than what they put in. Nonprofits with 501(c)(3) status are absolutely prohibited from allowing its assets to personally benefit any insider, including board members, officers, and key employees. Any incident of "excess benefit transactions" like overcompensating an insider can lead to revocation of the organization's exempt status or financial sanctions (excise taxes) imposed by the IRS. It is critical to set up policies that eliminate the temptation for insiders to take advantage of their involvement in the organization and to police the transactions that do occur within the nonprofit.

No Substantial Lobbying

The 501(c)(3) regulations prohibit qualifying organizations from participating in lobbying as a substantial portion of their activities. Lobbying, or attempting to influence legislation in any way, is allowed to some degree, but it cannot be a primary focus of the nonprofit. Also, there is a difference between lobbying and merely being involved in public policy. Lobbying is defined as advocating for or against, or contacting, or urging the public to contact, members or employees of a legislative body (Congress, state legislature, local councils, and the like) for the purpose of proposing, supporting, or opposing legislation. Activities such as distributing educational materials or hosting educational meetings about public policy issues is allowed and will not jeopardize the organization's tax-exempt status.

No Political Campaigning

Section 501(c)(3) also prohibits organizations from participating in the support or opposition of any political candidate. Donating funds to a campaign and making public statements for or against a political candidate risks the revocation of the nonprofit's exempt status and subjects the organization to financial sanctions. However, 501(c)(3)s are allowed to participate in the electoral process as nonpartisan players, such as providing voter education and encouraging voter registration, as long as there is no indication of support or opposition for any side of the election.

These five factors are the foundation of qualifying for 501(c)(3) status, and thus providing a nonprofit organization tax-exemption and the potential for donors to deduct their contributions. It is critical for all nonprofit founders to understand and adhere to each of these in order to protect the benefits that come with 501(c)(3) status.

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