What Is the Difference Between Nonprofit and Tax-Exempt Status?

The terminology used to describe nonprofit organizations often generates much confusion. Consequently, it is useful to clarify two key terms. Nonprofits are generally organized and operated as both nonprofit and tax-exempt entities. “Nonprofit” status refers to incorporation status under state law; “tax-exempt” status refers to federal income tax exemption under the Internal Revenue Code.

One who doesn't know otherwise might reasonably conclude that as nonprofit, tax-exempt entities, nonprofits may not earn profits (realize more income than expenses) and that they need not pay any taxes. Neither conclusion is correct.

Nonprofit organizations are permitted to generate greater income than expenses and still retain their “nonprofit status.” As nonprofit organizations, what these entities are barred from doing is distributing their net earnings to individuals or entities who control the organizations. Similarly, they are barred from accumulating equity appreciation for private benefit. Nonprofits have chosen to undertake programs to benefit their purposes and mission rather than private individuals or entities. Their earnings, therefore, must, by law, be dedicated to furthering the purposes for which they were organized. Nonprofit organizations have no shareholders and pay no dividends – all earnings are "reinvested" in the organization in furtherance of its nonprofit purposes.

Most nonprofits are also tax-exempt entities, but they need not be. Because the requirements for federal income tax exemption are more stringent than those for nonprofit corporation status, there are some organizations that are nonprofit corporations but do not qualify for exemption from federal income tax. While such an organizational form can be a useful structure for some entities – sometimes referred to as “taxable nonprofits” – they are few and far between.

Most nonprofit organizations qualify for federal income tax exemption under one of the dozens of subsections of Section 501(c) of the Internal Revenue Code. The vast majority of all nonprofits are tax-exempt under Section 501(c)(3), most trade and professional associations are tax-exempt under Section 501(c)(6), and most social welfare organizations are tax-exempt under Section 501(c)(4). In addition, it is not uncommon for 501(c)(6) associations or 501(c)(4) social welfare organizations to form related charitable or educational foundations exempt under Section 501(c)(3) – or vice-versa, with the 501(c)(3) entity forming an affiliated 501(c)(4) entity, for instance, in order to engage in otherwise-limited lobbying activities and/or otherwise prohibited political campaign activities – along with other taxable and/or tax-exempt subsidiaries or affiliates. Generally, there is a certain level of control and affiliation by and between such entities in both governance and operations.

But what does tax exemption mean? Does it mean that an organization is exempt from all taxes? No. Federal tax-exempt status means that the organization is exempt from paying federal corporate income tax on net income generated from activities that are substantially related to the purposes for which the entity was organized (i.e., to the purposes for which the organization was recognized tax-exempt by the IRS).

The organization must, however, pay federal and state corporate income tax (at the federal corporate income tax rate of 21 percent in addition to state corporate income taxes) on net income from regularly carried-on trade or business activities which are not substantially related to its tax-exempt purposes, called unrelated business income (UBI). Note that there are numerous exceptions and exclusions from unrelated business income tax (UBIT), such as for interest, dividends and capital gains, non-debt-financed rent, royalties, corporate sponsorships, and convention and trade show revenue. Organizations that meet the requirements for federal tax exemption can generally rely on that status to exempt their income from state corporate income tax, and most states generally tax UBI in the same manner as the IRS.

However, most nonprofits that are tax-exempt do remain subject to a wide variety of other taxes, including federal payroll (Social Security, Medicare and unemployment) taxes, state and local unemployment taxes, state and local real property taxes, state and local sales and use taxes, state and local franchise taxes, and federal taxes on lobbying and political activities (in some cases), among others. Exemptions for certain state and local taxes are sometimes provided for certain types of charitable organizations, as well as certain colleges and universities, hospitals and other entities.

Nonprofits organizations are required to comply at all times with the strict guidelines for both federal tax exemption and nonprofit corporate status in order to maintain their favored status under federal and state tax codes and state corporation laws. Failure to comply can lead to enforcement by the IRS at the federal level and by the Attorney General of the state of incorporation at the state level.

For more information, contact the author at jtenenbaum@TenenbaumLegal.com.