Paying taxes is an obligation, whether you’re a part-time employee or you run your own business. But for some, taxes aren’t a necessary part of life. This usually applies to entities that have applied for and achieved tax-exempt status. There are a variety of ways you can get tax-exempt status, either as an individual or an organization, but you’ll have to meet the IRS’s requirements first.
Tax Exempt Definition
The IRS exempts some transactions from tax liability based on certain criteria. When something is tax-exempt, it is free from taxation. But the IRS isn’t the only authority that can grant tax-exempt status. Transactions can be tax-exempt at the local, state or federal level. Tax-exempt can be confused with a tax deduction, but they are not the same. A tax deduction is used to reduce a person’s taxable income, while a tax-exempt transaction doesn’t even need to be reported to the IRS, unless it is included for informational purposes. One type of tax-exempt income is the interest you receive from municipal bonds.
Tax-exempt organizations are those that have applied for and obtained status as tax-exempt from federal or local authorities. These organizations are often called 501(c)(3) organizations, which relates to the section of the IRS tax code specific to exempting certain nonprofits. In order to get this designation, an organization must submit Form 1023, attaching all required documents, including articles of incorporation or articles of organization.
Types of Tax-Exempt Organizations
When you think of tax-exempt organizations, your mind may automatically go to churches and charities. While these are two types of entities that generally qualify for an exemption, there are many other types of organizations that can also apply and obtain it. Agricultural and horticultural organizations, social clubs, fraternities and sororities, veterans’ organizations and political organizations may also qualify. There are also trusts and child care organizations that may be exempt, as long as they apply and get IRS approval.
However, just falling into one of these areas doesn’t automatically qualify you for tax-exempt status. You’ll need to obtain an Employer Identification Number and submit the proper forms. You’ll also be required to pay a fee along with your application. Due to high application volume, the IRS warns it can take a while to hear back from them, but they state that you should hear something within 90 days. If not, you can contact the IRS through its toll-free customer account services number, which is 877-829-5500.
Do Nonprofits Pay Taxes?
Being granted tax-exempt status does not guarantee you’ll never pay taxes on anything you buy or sell. If a tax-exempt entity engages in activities that aren’t directly related to their stated mission or purpose, those purchases and sales won’t be tax exempt. But nonprofits that have been granted tax-exempt status don’t pay taxes on income that comes in related to their mission. They also can make purchases and sales connected to their purpose without paying sales tax, as long as they maintain their tax-exempt status.
Nonprofit organizations also must withhold and pay employee taxes as any business with workers would. That church secretary who takes a salary for working in the office full-time each week is paid just as he would be if he worked in an office setting. The same goes for the clergy who lead church members. Their income is taxed, but whether those taxes are withheld and submitted by the church depends on if they’re on the payroll or they work on a contractor basis.
Tax-Exempt Status for Individuals
The tax-exempt definition doesn’t just apply to organizations. Individuals can be tax-exempt, as well. This is known as “claiming an exemption,” and there are special circumstances where it applies. In that situation, you can instruct your employer not to withhold taxes on the income you earn by checking box 7 on the Form W-4 you complete when you start a new job. In order to claim tax-exempt status, though, you’ll have to either have had no tax liability in the previous year, giving you a right to a refund of all tax that was withheld for you, or this year you expect to have a refund of all income tax that will be withheld because you have no tax liability. However, in this case, you aren’t tax-exempt as much as exempt from taxes being withheld from each paycheck.
There are, however, instances where individuals are tax-exempt. Clergy may be required to pay income taxes on their earnings, but if they are opposed to insurance due to religious reasons, they can apply for an exemption from paying self-employment tax, since that is a form of insurance. To do this, you’ll need to complete Form 4361. Students in the country on certain visas may be exempt from taxes on wages as long as they’re paid for services related to the visas they obtained.
What Is an Exemption?
One term that can be easily confused with “tax-exempt status” is an exemption, which is something you claim on your taxes to reduce your taxable income. Until the Tax Cuts and Jobs Act, the IRS allowed two types of exemptions to taxpayers – personal and dependent. The personal exemption went away under the new tax law, but at the same time, the standard deduction nearly doubled to make up for it. One exemption that’s still in place, though, is the dependent exemption, which applies to children under the age of 18 who are living with you. That exemption doubles under the new tax law.
Although organizations and businesses aren’t eligible for any exemptions, they offset their taxable income through the use of deductions. A tax-exempt entity deals with these deductions when accepting contributions from donors. Those donors claim the contributions on their own taxes, which is why they’ll ask for a receipt. A nonprofit with no taxable income won’t have the need to claim deductions, since there’s no need to offset taxes they’re paying.
Maintaining Tax-Exempt Status
Landing tax-exempt status is only the beginning. Tax-exempt organizations are not guaranteed the status from one year to the next. You’ll be expected to follow the rules specific to nonprofit organizations, including keeping full accounting of all of your activities. Each dollar you bring in and send out should be able to be linked to your organization’s stated purpose and, if not, you should pay taxes on that money and keep documentation that you’ve done so. You’ll need to claim this income if you exceed $1,000 in a tax year. If you have a gift shop, for instance, and the proceeds don’t go directly to funding your core mission, you’ll need to track that income and pay taxes on it once it exceeds the maximum.
Perhaps most important for a tax-exempt entity, though, is having oversight. A board of directors that meets regularly, has access to your books and holds your organization accountable can make a big difference. You should watch your books carefully for any signs of activity that doesn’t fit the tax-exempt definition of your organization. If any income coming in benefits an employee or board member personally, you could find yourself in hot water, both with the IRS and with those who donate money or time to your organization. If your organization dissolves, the money cannot go to any individual or group of individuals for personal gain. It will have to be donated to another nonprofit.
- Applying for Tax Exempt Status | Internal Revenue Service
- Foundation Group: What is a 501(c)(3)?
- IRS.gov: Exempt organizations - organizing documents
- IRS.gov: Types of Tax-Exempt Organizations
- IRS.gov: Frequently Asked Questions About Applying for Tax Exemption
- IRS.gov: Where's My Exemption Application?
- Avalara: Nonprofits and Sales Tax
- IRS.gov: Topic Number 417 - Earnings for Clergy
- IRS.gov: Tax Withholding for Individuals
- IRS.gov: Social Security/Medicare and Self-Employment Tax Liability of Foreign Students, Scholars, Teachers, Researchers, and Trainees
- Can I Claim Exemption From Withholding on Form W-4? | Internal Revenue Service
- LegalZoom: Maintaining Tax Exempt Status in a Nonprofit
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.