How Is a Nonprofit Corporation Taxed?

Federal Taxes

As we alluded to, a nonprofit corporation is not automatically exempt from taxes, and that includes federal income taxes. However, many nonprofit corporations can apply for tax exemptions.

Most charities, nonprofit hospitals, education groups, public safety organizations, and religious organizations can gain tax-exempt status as a 501(c)(3).

501(c)(3) is by far the most common designation for tax-exempt nonprofits, but a few other nonprofit types can file as a 501(c)(6). For the remainder of this section, we’ll discuss 501(c)(3)s, but if you want more information on the (c)(6), which grants exemption to business leagues, real estate boards, chambers of commerce, professional football leagues, and more — visit the IRS website.

To qualify as an exempt 501(c)(3), the nonprofit’s bylaws and articles of incorporation should include language that demonstrates its charitable identity. You can draft your own articles, but the IRS also offers a template to make the process easier.

In addition to this wording, the nonprofit corporation must complete IRS Form 1023. Filling out this application can take a lot of time, seeing as it’s nearly 30 pages long. Once the IRS receives your application, it can take approximately three to five months to approve the application. Since it takes a long time to complete, you should do your best to get your application in well before the date you need the exemption to take effect.

Once the application is accepted, the IRS will send you a certificate of exemption. You should keep this in your business records, because you may need copies of it later (more on that under state taxes).

This process will exempt your corporation from federal income taxes. That said, you’ll still be expected to file IRS Form 990, which serves as an income report.

State Taxes

Each state gets to make its own decision about the tax exemptions it offers. While each one is different, many offer exemptions for income taxes, sales taxes, and property taxes.

Income taxes

Many states will allow you to apply for an exemption from several tax types, the most common being income taxes.

Each state has its own application process, but many allow the IRS’s decision to take precedence. In these cases, if you already have a federal exemption, the process is simple. Usually you’ll just need to provide a copy of your exemption letter to the state, and they will exempt you from state income taxes.

States that accept IRS determination letters as a means of establishing exemption from state income taxes (or that have no state corporate income tax to begin with) include:

Alabama, Alaska, Arizona, Colorado, Delaware, Hawaii, Idaho, Illinois, Iowa, Kansas, Kentucky, Maine, Michigan, Minnesota, Missouri, Nebraska, New Hampshire, New Jersey, New Mexico, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, South Dakota, Tennessee, Vermont, Virginia, Wisconsin, and Wyoming.

Other states have a unique application process. You should consult with your state’s Department of Revenue to learn about how you can apply for tax exemption. Even if you’re exempt from income taxes, your state will likely require an annual finance report, much like the IRS’s Form 990.

Sales taxes

Each state makes its own decisions regarding sales taxes, including the rate and who can be exempt from the tax. Usually, the exemption goes to charities, education groups, and religious organizations.

Exemption from sales taxes can work in one or both of two ways: the nonprofit corporation will not have to pay sales taxes on the goods it purchases, or it will be exempt on goods it sells. (Purchase-based exemptions are much more common).

You should consult your state’s Department of Revenue or similar agency to determine how sales taxes apply to nonprofits.

Property taxes

The issue of property tax is a bit simpler to understand. Any property owned by a charitable nonprofit, and used entirely for tax-exempt purposes, is exempt from property tax laws in every state.

Some experts estimate that the property tax exemption save nonprofits up to $32 billion per year, which is nearly 10% of all the property taxes paid in the United States.

Critics of the nonprofit property tax exemption point to the fact that these buildings still use municipal services, and therefore every dollar they save is a dollar the city has to make up from other businesses and homeowners. Still, it does not appear that much progress is being made to change this law, so if you own a nonprofit with certified tax-exempt status, you will not have to pay property taxes in any state.

Conclusion

As we’ve seen throughout this guide, the taxes for one nonprofit will not look the same as those of another. There are too many differences from one state to the next for us to be able to say with any certainty which types of taxes your specific nonprofit will be subject to.

In addition, not all nonprofits are tax-exempt to begin with, so for some of these organizations, taxation will look rather similar to that of a normal corporation.

We highly recommend that you consult your state’s website for full details on exemptions in your area. With that input, you can have confidence that you’ve either paid the amount you’re responsible for, or received an exemption for each tax type.

If you have any further questions after that, you should probably enlist the assistance of an accountant or lawyer to help you understand the nuances of nonprofit tax law.