Tax-Exempt Entities

Often referred to as “nonprofit” organizations, certain corporations and trusts are exempt from federal income tax. The earliest manifestation of tax exemption in common law traces to the British Statute of Charitable Uses in 1601. Most  present exemptions in Subchapter F, found in IRC §§ 501-528, were enacted as part of the Revenue Act of 1894.

Two fundamental types of exempt organizations exist for federal tax purposes: “public service organizations” and “mutual benefit organizations.”

Public service organizations, commonly referred to as “501(c)(3) organizations,” are organized and operated exclusively for religious, charitable, scientific, literary or educational pruposes. Common examples of 501(c)(3) organizations include churches or synagogues, organizations to prevent cruelty to animals, and organizations devoted to curing diseases.

Mutual Benefit Organizations, described in IRC § 501(c)(6), as their name implies, although not operating for profit, serve the interests of members seeking to pursue professional or personal objectives. Such organizations woudl include social clubs, fraternal societies, labor unions, trade associations, or homeowners’ associations. A common example of a trade association would be the American Bar Association.

While both 501(c)(3) and 501(c)(6) organizations generally enjoy tax-exempt status, important differences exist in the taxation and governance of such entities. For example, the deductibility of contributions to these entities differs markedly. While charitable contributions to 501(c)(3) organizations are deductible under IRC § 170, contributions to 501(c)(6) entities are deductible, if at all, as ordinary and necessary business expenses under IRC § 162. This difference may play a critical role in the deciding whether to seek qualification under 501(c)(3) or 501(c)(6).

The Regulations impose additional requirements for these tax-exempt entities. To qualify under 501(c)(3), the organization must limit activities to the pursuit of its exempt purposes, and must not attempt to influence legislation. To illustrate, The ASPCA could not, consistent with its tax-exempt charter, operate a chain of motels for profit, and could not attempt to influence legislation concerning greenhouse gases.

To qualify under 501(c)(6), the organization must promote a common business interest, and its activities must be directed to improve business conditions in one or more “lines of business.” The ABA, for example, consistent with its charter, could not operate to improve the business conditions of the film industry, nor could it open a law firm for profit. However, trade associations are free to pursue political activities and in fact are often formed to promote a legislative agenda.

501(c)(6) organizations risk losing their exempt status if they operate regular businesses, even if income is sufficient only to sustain the organization. 501(c)(3) organizations are accorded more latitude in this regard, and may pursue business activities provided the business is in furtherance of the organization’s exempt purpose, and the organization is not operated primarily for carrying on an unrelated trade or business. Although both types of organizations risk losing tax-exempt status engaged in business activites, imposition of tax on unrelated business income at ordinary corporate or trust rates is a less severe sanction imposed by the Code.

Reporting requirements for 501(c)(3) organizations are more stringent than for 501(c)(6) organizations; the former is required to submit annually balance sheets, names and addresses of substantial contributors, as well as names and addresses of officers, directors and trustees.

A futher distinction must be made among organizations qualifying under 501(c)(3). Public charities receive most funding through contributions from the general public. If contributions from private funding reaches a certain threshold, the entity is a private foundation. Various reporting and excise tax penalties are imposed on private foundations, as these entities are perceived to present a threat tax abuse.

Under New York State law,  organizations which solicit public contributions — generally 501(c)(3) entities — are required to register with the Attorney General under EPTL §8-14. Although 501(c)(6) organizations are generally exempt from such registration, their applications must be approved by the Antitrust Bureau of that office.  The formation, operation and governance of tax-exempt entities are regulated by NY Not-for-Profit Corporation Law.

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