Nonprofit vs. Tax-Exempt – What’s the Difference?

Nonprofit vs. Tax-Exempt – What’s the Difference?

The terms “nonprofit” and “tax-exempt” are often used interchangeably, but there is a difference. What is that difference? The answer is not that simple.

Not all nonprofit organizations are tax-exempt, and not all tax-exempt organizations are nonprofit organizations. The distinction lies in understanding the context of “nonprofit” and “tax-exempt,” the different types of nonprofit organizations, and the rules that apply to those different types of organizations.

“Nonprofit” is a concept of state law, denoting an organization that does not distribute any profits or surplus to shareholders, members, or other individuals. In general, any surplus generated by the organization must remain with the organization and be used for the organization’s stated purpose. A nonprofit corporation is not owned by any person, entity, or other organization. Individuals or another organization may control it, but there are no ownership interests. Each state has its own nonprofit corporation law providing provisions, regulations, and guidelines for nonprofit organizations incorporated in the state.

“Tax-exempt” is a status granted by the Internal Revenue Service (IRS) to organizations seeking exemption from federal income tax under section 501(a) of the Internal Revenue Code. Most, but not all, nonprofit organizations are tax-exempt. Section 501(c) of the Internal Revenue Code lists 28 separate categories of exempt organizations, including section 501(c)(2) title holding companies, section 501(c)(4) social welfare organizations, and section 501(c)(6) business leagues, trade associations, and similar organizations.

The largest category of exempt organizations is section 501(c)(3) charitable organizations. This exemption applies to entities organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, to name a few. Charitable organizations are prohibited from conducting political campaign activities to influence elections to public office, from devoting a substantial part of their activities to influence legislation, and from using any part of the organization’s net earnings to benefit any individual.

While section 501(c) organizations may have a tax-exempt status, they are not exempt from all taxes; they are still responsible for remitting payroll, state and local (where applicable), and property taxes, and some may be subject to tax on unrelated business income derived from activities not directly associated with the organization’s mission.

The IRS requires these organizations to submit annual informational filings, similar to the annual income tax reporting required of for-profit companies. Most organizations exempt from income tax under section 501(a) must file an annual information return or notice, depending upon the organization’s gross receipts and total assets.

Some tax-exempt organizations are not required to file the annual information return due to the nature of the organization and/or its mission. These include certain religious organizations (i.e., a church, a church-affiliated organization, or a school below college level affiliated with a church or religious order), certain governmental organizations (i.e., a governmental unit or affiliate of a governmental unit, or a corporation organized under an Act of Congress that acts as an instrument of the United States), and certain political organizations (i.e., a state or local committee of a political party, or a caucus or association of state or local officials). Failure to understand and to acknowledge these compliance items and related reporting requirements could subject the organization to fines and penalties, and the potential loss of its tax-exempt status.

While the answer to the question in this article’s title is not simple, the contexts of the two classifications are fairly straightforward. Understanding how the organization was originally conceived with respect to its purpose and mission will guide you in applying the correct provisions.

Elizabeth F. Pilacik can be reached at epilacik@kmco.com or 215.441.4600.

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