6 Benefits (and 4 Risks) When Starting a 501c3 Organization

Jan 18, 2024 

Disclaimer: Although we do not provide financial or legal advice, we can assist you with your filings and corporate documents and help you apply for 501(c)(3) status under the Internal Revenue Code (IRC). Visit our service pages to find out more about what Pearl Solutions can offer. 

6 Benefits (and 4 Risks) When Starting a 501(c)(3) Organization

If you have a vision of how you can improve your community and have a positive impact on the world, you may be considering starting a 501c3 or 501(c)(3) nonprofit organization to facilitate that work. 

As you’ll see below, there are many benefits to having 501(c)(3) status. We’ve also included a few things to keep in mind so you don’t put that status at risk. 

Definition of 501(c)(3) Status

What does it mean to have 501(c)(3) status or be a 501(c)(3) organization? When an organization has achieved this status or designation, it means that the Internal Revenue Service (IRS) has determined that the organization is tax-exempt*. 

In order to qualify for 501(c)(3) status, you must send in an application to the IRS and prove that your organization meets the exempt purposes defined in section 501(c)(3) of the IRC. According to the IRS, a 501(c)(3) organization:

“…must be organized and operated exclusively for exempt purposes set forth in section 501(c)(3), and none of its earnings may inure to any private shareholder or individual. In addition, it may not be an action organization, i.e., it may not attempt to influence legislation as a substantial part of its activities and it may not participate in any campaign activity for or against political candidates.”

You can learn more on the IRS website

What is the Difference Between Nonprofit and Tax-Exempt?

Is there a difference between nonprofit status and tax-exempt status? Yes, there is. If this is news to you, you’re not alone. It’s a frequently asked question

This is how the IRS explains the difference:

“Nonprofit status may make an organization eligible for certain benefits, such as state sales, property, and income tax exemptions. Although most federal tax-exempt organizations are nonprofit organizations, organizing as a nonprofit organization at the state level does not automatically grant the organization exemption from federal income tax.”

In short, state law governs an organization’s nonprofit status. The federal government determines whether or not that organization has 501(c)(3) status and is exempt from paying federal income tax. 

Benefits of Starting a 501(c)(3) Organization

1. Tax Exemptions 

The most obvious benefit of being a 501(c)(3) organization concerns tax exemption. 

Federal Income Tax Exemption

Organizations that have 501(c)(3) status are exempt from paying federal income tax under section 501(c) of the IRC. 

Property Tax and Sales Tax Exemptions

Your organization’s exemption from paying certain taxes—like property tax or sales tax—will depend on your local and state laws. As mentioned above, tax-exempt status and nonprofit status are not interchangeable. Don’t assume your nonprofit is automatically exempt from paying local and state taxes just because it’s exempt from paying certain taxes on the federal level.

Ultimately, it’s your responsibility to ensure your organization is in compliance with local, state, and federal laws around tax exemption. When in doubt, we recommend seeking advice from an accountant who is familiar with tax law and how nonprofits operate in your area. 

2. Public Charitable Deduction for Donations

Another benefit of maintaining 501(c)(3) status is that donations or charitable contributions to your organization are likely tax-deductible. This means that donors can itemize their deductions and adjust their gross income by a certain percentage based on the amount that they contributed to different 501(c)(3) organizations over the course of the filing year. This incentive may motivate people to donate to your organization. 

3. Limited Liability Protection

A Limited Liability Company (LLC) is a legal status or business structure that offers the owner and/or members limited liability. 

Protection From Personal Liability for Directors and Officers

When nonprofits are organized in this way, owners, board members, and other members usually have limited personal liability. As noted by the Nonprofit Risk Management Center, some bylaws include a promise to indemnify directors and officers for certain actions conducted while acting in those roles. Some states are actually required to do so.

As with tax exemption, it’s important that you don’t assume a certain level of financial or personal liability. Look into your local, state, and federal laws and make sure you understand what your protections and risks are. 

Limiting Risk for Business Owners and Others Involved in the Corporation

When someone has limited financial liability, their liability is limited to a fixed amount; the fixed amount is usually the value of their investment in the organization. Organizing as an LLC limits the financial risk for business owners and others involved in the corporation. 

4. Perpetual Existence 

As with limited liability, perpetual existence concerns the separation between a person and an entity. Nonprofits continue to “live” or “exist” even if a director or certain designated members die or leave the organization.

5. Financial Benefits of 501(c)(3)

Another financial benefit that 501(c)(3) organizations enjoy is their access to certain grants or funds. 

Private Grants Available to 501(c)(3) Organizations

In order to apply for private grants, organizations have to meet certain eligibility requirements. Often, funders only open grants up to organizations with 501(c)(3) status. When you achieve this status, you’ll be eligible to apply for grants that are only available to 501(c)(3) organizations. This means you now have access to a wide source of funding that would otherwise not be available to your organization. 

Looking to apply for a grant but aren’t sure where to start? Learn about the grant proposal writing services and grant management services we provide. 

Tax-Deductible Contributions From Individuals

Donations made to most 501(c)(3) nonprofits are considered tax-deductible. This may motivate potential donors to make a contribution to your organization. 

6. Nonprofit Status Recognition

People want to donate to organizations they can trust. An easy way to quickly determine an organization’s trustworthiness is to see if it has 501(c)(3) status.

Risks Involved When Starting a 501(c)(3) Organization

There are many benefits of 501(c)(3) status. Unsurprisingly, there are also risks to maintaining that status. These mostly involve compliance issues or what your organization cannot do if you want to receive and/or maintain your 501(c)(3) tax-exempt status. 

To minimize the risk of losing your status, follow the rules affecting these four areas. 

1. Private Benefit Accusations

Regarding private benefit and inurement accusations, the IRS states that: 

  • Private benefit: A 501(c)(3) organization’s activities should be directed toward some exempt purpose. Its activities should not serve the private interests, or private benefit, of any individual or organization more than insubstantially.
  • Inurement: A 501(c)(3) organization is prohibited from allowing its income or assets to benefit insiders—typically board members, officers, directors, and important employees of an organization. 

Certain people involved with the organization could be subject to sanctions like penalty excise taxes if they break these rules. 

2. Corporate Lobbying

According to the IRS, while an organization with 501(c)(3) status can lobby in some cases, “too much (lobbying) can hurt its tax-exempt status. Its lobbying activities cannot be more than an insubstantial part of its overall activities.” 

3. Getting Politicized

These organizations are also restricted from participating in certain political activities. They are “absolutely prohibited from directly or indirectly participating in, or intervening in, any political campaign on behalf of (or in opposition to) any candidate for elective public office.”

4. Unrelated Business Income (UBI)

501(c)(3) organizations aren’t exempt from every type of tax. The IRS defines unrelated business as an activity that is subject to UBI tax if it meets these requirements:

  • It is a trade or business.
  • It is regularly carried on.
  • It is not substantially related to furthering the exempt purpose of the organization.

Information on exceptions and exclusions can be found here

Conclusion

There are many reasons why you may want to apply for 501(c)(3) status. If you need support, our team can streamline the lengthy and complicated process of starting and developing a nonprofit or mission-driven corporation. Our services include corporate registration, IRS 501(c)(3) tax-exempt recognition application, formulation of bylaws, and more. 

*Pearl Solutions doesn’t provide legal or financial advice. Please direct any financial or legal inquiries to your accountant or lawyer.

If you’re looking to apply for and win a world-changing grant, we’d love to support you. Learn more about the grant proposal writing services we provide at Pearl Solutions. 


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