Building a business
Nonprofit? Not simple
After the Minnesota Supreme Court ruled in December that a small nonprofit day
care center had to pay property taxes, many observers began to point to growing
confusion about nonprofits. It comes at a time when governments are facing increasing
pressure to scrape up funds for education, health care, and other public services.
Forming and operating a nonprofit is not simple. For a better understanding,
let’s look at some basic characteristics of nonprofits and how they qualify
for tax exemptions.
Who defines nonprofit?
We generally think of a nonprofit organization as one that provides
a public service to the community. A food bank, for example,
receives donations to help feed the poor. By contrast, a for-profit
organization sells goods and services to make a profit.
Apart from its informal definitions, nonprofit is a legal term
embedded in a body of law. Simply put, nonprofit status is conferred
by the IRS under Section 501 of the U.S. Tax Code. This code
section lists several types of nonprofits: charities such as
the Red Cross, foundations such as the Hogg Foundation for Mental
Health, professional groups such as the American Medical Association,
religious organizations, and social welfare organizations.
Nonprofit status has advantages, notably certain tax exemptions.
Governments grant tax exemptions because nonprofits provide public
services and help lessen a government’s burden of protecting,
educating, and providing for the well-being of citizens.
Another advantage is that nonprofits can apply for government
and foundation grants intended specifically for nonprofits. They
can also solicit donations from corporations and individuals,
who can then turn around and deduct their donations from their
How to get nonprofit status?
To the IRS, churches and religious organizations are nonprofits
under the principle of separation of church and state, as provided
in the U.S. Constitution. A child care center operating within
a church is a de facto nonprofit, unless there are reasons
for it to obtain nonprofit status on its own. The church board
may decide that a separate entity would reduce liability if
a child were injured, for example.
Forming a nonprofit organization can be a long, complicated,
and expensive process and is best done with a tax attorney. Space
does not permit listing all the steps here, but mainly the organization
forms a nonprofit corporation as provided by state law and then
files an application with the IRS.
Forming a legal entity is essential to transacting business—opening
a bank account, owning property, and providing a way for the
organization to continue after its founding members pass on.
To incorporate, the organization files articles of incorporation
with the secretary of state’s office.
The articles of incorporation contain provisions that taxing
authorities will scrutinize. A few key provisions include the
mission statement that describes the organization’s charitable
or educational purpose,
board of directors to guide the organization in its mission
and to oversee legal and financial obligations,
statement that none of the organization’s net earnings
may benefit any of its officers, directors, or private individuals,
except for reasonable compensation for services actually rendered,
dissolution provision, naming a public entity that will receive
the assets if the organization dissolves.
The application to IRS is critical. The tax exemption granted
by IRS applies only to the federal income tax generally paid
by corporations on their net earnings. But in actuality, a favorable
IRS determination opens the door for other tax exemptions.
The most well-known IRS tax-exempt classification is the 501(c)3.
To determine whether an organization qualifies, the IRS requires
extensive documentation such as bylaws, activity descriptions,
and financial statements. The organization must show, among other
things, that it operates exclusively for its stated public purpose.
In addition, the organization is restricted in lobbying and political
Exactly what kind of 501(c)3?
Within the 501(c)3 classification are subcategories that can
have a huge impact on an organization’s operation. If
a child care center’s mission is to provide child care
and education, for example, the IRS may classify it as an educational
organization or private school. In this case, the requirements
include a firmly established and demonstrated policy of nondiscrimination.
As another example, if a child care center’s mission is
to serve poor families, the IRS may classify it as a public charity.
In this case, the requirements include a broad base of financial
support from donations, grants, and fees. If two-thirds or more
of donations come from one or two families or corporations, however,
the IRS may classify the organization as a foundation and treat
it differently for tax purposes.
Learn more about requirements at www.irs.gov/pub/irs-pdf/p557.pdf.
Other possible tax exemptions
A 501(c)3 determination is necessary for other tax exemptions
but by no means guarantees them. Here’s a summary:
corporate income taxes. Exempt from taxes on earnings
from services directly related to the organization’s charitable
or educational mission, but not exempt on $1,000 or more from
earnings on unrelated goods and services such as selling T shirts.
on employees, notably federal income tax withholding (FICA),
Social Security and Medicare, and unemployment. Not exempt.
income tax. Depends on laws and regulations of states that
have a state income tax.
business or franchise tax. Depends on laws and regulations
of the state. In Texas, educational and charitable nonprofits
may be exempt (Texas Tax Code, Sections 171.061 and 171.062).
and local sales taxes. Depends on laws and regulations
of the state. In Texas, religious, educational, and public service
nonprofits may be exempt (Section 151.310).
taxes. Depends on laws and regulations of the state.
In Texas, charitable nonprofits and private schools may be exempt
(Sections 11.18 and 11.21).
Maybe tax-exempt. Maybe not.
The Minnesota court’s ruling that the Under the Rainbow
center in Red Wing was not exempt from property taxes turned
on the state’s criteria for a public charity—in essence,
whether the center provided a free service. It didn’t.
It charged the same price for every child regardless of the family’s
ability to pay or eligibility for government support. For the
full opinion, see www.kiplinger.
In a 1998 case in Austin, Texas, the Circle C Child Development
Center was denied a property tax exemption because it didn’t
qualify as a school under Section 11.21 of the Texas Tax Code.
The Texas Court of Appeals, Third District, said the center,
which is accredited by the National Association for the Education
of Young Children, provided primarily “custodial care,” did
not keep normal school hours, and did not serve children of school
age, except for a couple of hours after school. For the full
opinion, see http://bulk.resource.org/
The lesson here is that nonprofits can’t predict whether
they will get a property tax exemption. But the bigger issue
may be the need to clarify what a nonprofit is and how much we
value the services nonprofits provide.
Circle C’s director Michelle Moran, says paying a hefty
property tax bill every year essentially reduces the amount of
care and education she can provide for working families. Michelle
Finholdt, director of the Red Wing center, says she can’t
afford to pay better staff wages or buy more educational materials.
Are these two examples a case of robbing Peter to pay Paul?
In May, Minnesota began taking steps to clear up the confusion
for its nonprofits. The legislature set a one-year ban on reversing
the property tax exemptions of existing nonprofits and called
on legislators to write criteria that would better define public