The formation of a religious or a not-for-profit organization carries with it much more than just tax implications.
Whether you wish to create a family foundation in connection with your estate plan, a public charity to heal a societal ill, or a religious corporation as a house of worship, it is important to note that the formation of a religious or a not-for-profit corporation carries with it much more than just tax implications.
While exemption from federal and state income tax, as well as other taxes, is a significant characteristic of a religious or a not-for-profit corporation, those who lead these entities must also comply with many non-tax regulations at both the federal and state level. If the entity fails to comply with the myriad of laws, it is in danger of losing its tax-exempt status or being subject to fines, sanctions and/or excise taxes.
Religious and certain not-for-profit corporations qualify for federal tax exemption under Section 501(c)(3) of the Internal Revenue Code. In general, these organizations must serve a public, rather than a private interest. These corporations cannot offer preferential treatment to certain groups of people, otherwise they would not be permitted tax-exempt status.
How to qualify as a tax-exempt organization
To qualify as a tax-exempt organization, the Internal Revenue Code provides that an entity must meet two tests: the organizational test and the operational test. To pass the organizational test, the entity must state in its charter or articles that its intent is to perform activities that warrant exemption, i.e., those that serve the public good. If the organization’s purposes and powers are limited only in its bylaws or by officers’ oral or written statements, it will not pass the organizational test.
The operational test is a three-prong test:
- What are the organization’s primary activities?
- How are its earnings distributed?
- Is it an action organization?
In order to be recognized as a tax-exempt organization, it is important to note that religious corporations must be organized and operated exclusively for a religious purpose. This purpose must be expressly stated in the entity’s bylaws or articles of incorporation. In addition, the organization must not primarily perform activities other than those that further its religious purpose. If its primary activities include anything other than religious activities, then the entity may not qualify for tax-exempt status.
Just like religious corporations must be organized and operated exclusively for a religious purpose, educational organizations must be organized and operated exclusively for an educational purpose. Instructing and training individuals to improve their capabilities or educating the public on subjects useful and beneficial to the public are examples of educational purposes that are deemed acceptable under the Internal Revenue Code. Social and recreational activities do not qualify as educational purposes.
Differences between “tax-exempt” and “non-profit”
A significant difference exists between the terms “tax-exempt” and “non-profit.” “Tax-exempt” is a federal term, which the Internal Revenue Service uses to recognize an entity as one that is organized and operated for a purpose designed to benefit the public at large. “Non-profit” is indicative of state law and often, but not always, corresponds to exemption from federal income tax. In other words, tax-exempt organizations are inherently not-for-profit in their missions; however, non-profit organizations are not always tax-exempt because they may not comply with the federal regulations that govern tax-exempt entities.