By Monika Briggs, CPA

Each year, numerous CPAs find themselves newly immersed in nonprofit finance roles. Some begin working for nonprofit entities professionally, either through a direct career transition or by adapting their client base to include nonprofit organizations. Still others actively contribute to their communities and accept volunteer positions on nonprofit boards, providing financial expertise for the organization’s benefit. In either scenario, CPAs soon learn that the nonprofit sector differs markedly from the for-profit world. Navigating the intricacies can be daunting.

This blog is the opening of a series born from the challenges I encountered and the insights I gained in my nonprofit experiences. When I stepped into a management role with a new organization, I assumed leadership of several nonprofit entities. I was in unfamiliar terrain with a steep learning curve. I quickly recognized the urgent need for a guide, which was notably absent at the time. This series is designed to serve as that foundational guide for CPAs who are new to the nonprofit space, enabling them to navigate the sector and gradually deepen their knowledge.

Beyond financial matters, CPAs are expected to be the compass for navigating a slew of regulatory and compliance issues. When a question arises, everyone turns to the CPA in the room with faith that she or he will know how to proceed. In this series, we will cover a range of critical topics, from understanding nonprofit status and navigating federal tax laws to ensuring ethical and legal compliance. Each monthly installment will delve into nonprofit management, providing practical guidance, real-world examples, and advice from subject matter experts and co-authors. The goal is to demystify the complex regulatory landscape and offer actionable strategies that empower you to navigate nonprofit compliance with confidence.

We launch with the basics: understanding nonprofit status. This will set the groundwork for all that follows and is crucial for every CPA working in or with nonprofit organizations.

Nonprofit and Tax-Exempt: Understand the Distinctions

The terms “nonprofit” and “tax-exempt” are often used interchangeably, but they represent different legal concepts. CPAs and nonprofit managers must understand the distinction, especially when it comes to compliance and filing requirements. The primary difference between nonprofit status and tax-exempt status is that nonprofit status pertains to an organization's mission and management of its income; tax-exempt status relates to specific tax benefits conferred by the IRS or other tax authorities. Importantly, nonprofits are not automatically tax-exempt. Obtaining tax-exempt status requires application to the IRS and ongoing compliance with federal regulations. Conversely, not all tax-exempt organizations are nonprofits in the traditional sense. For example, cooperatives may receive tax exemptions but operate in a manner that benefits members directly.

State-Specific Nature of Nonprofit Status

Nonprofit status in the United States is governed at the state level, which means each state has its own set of laws and regulations for nonprofit entities. Nonprofit status is granted when the organization is formed. Nonprofits are organized for purposes other than generating profit and are subject to specific restrictions:

• Profit Distribution: Nonprofit entities are prohibited from distributing profits to members, directors, or officers of the organization. Instead, all surplus funds after expenses must be reinvested back into the organization’s mission.
• Asset Distribution: Upon dissolution, a nonprofit’s assets must be transferred to another nonprofit entity, not to individuals or private entities.
• Organizational Purpose: Nonprofits must serve public, charitable, educational, religious, or similar purposes.
• Ownership and Governance: Nonprofits do not have owners. They are typically governed by a board of directors or trustees, who must adhere to strict governance and ethical standards.

In Pennsylvania, as in other states, the predominant legal form of nonprofit entity is the nonprofit corporation, although forms such as nonprofit cooperative corporations, associations, or trusts are also recognized. Title 15 of the Pennsylvania Consolidated Statutes governs corporations and unincorporated associations in the state, including both nonprofit and for-profit organizations. Subpart C – commonly known as the Nonprofit Corporation Law of 1988 or just Nonprofit Corporation Law – provides a comprehensive framework for the formation, governance, and operation of nonprofit organizations within Pennsylvania, outlining requirements for corporate structure, operational guidelines, and legal compliance to ensure that nonprofits are structured to qualify for federal tax-exempt status and adhere to state regulations.

Establishing and Maintaining Nonprofit Status in Pennsylvania

To establish and maintain nonprofit status under Title 15, organizations must first file Articles of Incorporation with the Pennsylvania Department of State, specifying their organizational purpose. Unlike the explicit definitions provided federally and discussed in the next section, Pennsylvania adheres to a broader common law definition of charity, which includes the relief of poverty, advancement of education and religion, promotion of health, governmental, or municipal purposes, and other purposes that benefit the community. For practical purposes, to ensure eligibility for tax-exempt status under the Internal Revenue Code (IRC), nonprofits in Pennsylvania typically structure their missions and activities to meet both state and federal guidelines.

Once established, maintaining nonprofit status in Pennsylvania requires strict adherence to governance practices prescribed by Title 15, including holding regular board meetings and keeping detailed financial records. The Nonprofit Corporation Law details the governance structure of a nonprofit, including provisions for the board of directors, officers, and members, how these individuals are elected, their duties, and their powers within the organization. The statute also provides guidelines on how nonprofit corporations should operate, including holding meetings, voting procedures, and maintaining proper records. It also addresses the handling of assets and accounting practices to ensure transparency and accountability. Finally, nonprofit corporations are required to file annual reports and other documentation with the state to maintain their active status and comply with regulatory oversight.

Tax-Exempt Status

Tax-exempt status is specifically related to the organization’s exemption from paying federal and, in many cases, state and local income taxes. This status is conferred by the IRS and sometimes by state and local tax authorities. To qualify, nonprofit corporations must align with specific requirements outlined in the IRC. The IRC categorizes over 30 distinct types of tax-exempt organizations under various subsections of Section 501(c). Each is defined by unique exemption characteristics and operational conditions that must be fulfilled to maintain tax-exempt status. For instance, some of the most commonly recognized types include the following:

• 501(c)(3): Charitable, religious, educational, scientific, and literary organizations.
• 501(c)(4): Social welfare organizations and local associations of employees.
• 501(c)(5): Labor, agricultural, or horticultural organizations.
• 501(c)(6): Business leagues, chambers of commerce, real estate boards.
• 501(c)(7): Social and recreational clubs.
• 501(c)(8): Fraternal beneficiary societies and associations.
• 501(c)(19): Veterans’ organizations.

The primary benefit of tax-exempt status is the exemption from federal income tax. To receive federal tax-exempt status, nonprofits must apply to the IRS. Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, is the standard application for tax exemption under Section 501(c)(3). Form 1023 requires extensive documentation of the organization’s structure, governance, finances, and activities. Smaller organizations – those with gross receipts of $50,000 or less and assets up to $250,000 – can use the streamlined Form 1023-EZ. Other organizations might need to submit Form 1024 or a different application depending on their exemption category. Preparation for these applications also includes obtaining an EIN, crafting bylaws and a conflict of interest policy, and compiling supporting documents like financial statements, activity descriptions, and fundraising plans.

After submission, the timing of IRS's final determination could vary from a few months to over a year, depending on the application’s complexity and IRS backlog.

Organizations with tax-exempt status must adhere to strict IRS regulations concerning their operations, financial transparency, and the extent of their political activities, among other things. Most tax-exempt organizations are required to file annual returns with the IRS (such as Form 990) and maintain meticulous records to demonstrate compliance with the terms of their tax-exempt status.

Tax Deductibility of Donations to 501(c)(3)s

A significant advantage of tax-exempt status is the ability for donors to deduct their contributions to 501(c)(3) organizations from their taxable income. It’s crucial to note, however, that not all donations to tax-exempt organizations are deductible as charitable contributions. Practically speaking, only donations to 501(c)(3) organizations are deducted as charitable donations. Other specific types of organizations, such as certain 501(c)(19) veterans’ organizations and 501(c)(13) nonprofit cemetery companies, may receive tax-deductible contributions under certain conditions. However, 501(c)(3) entities are the most frequent recipients of tax-deductible charitable donations due to their structures and purposes.

Entities that qualify for exemption under Section 501(c)(3) of the IRC must be organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes. They can also qualify if they foster national or international amateur sports competition, or if they are involved in the prevention of cruelty to children or animals. These entities must not only be organized for these specified purposes but must actively pursue them. Additionally, they must not distribute earnings, engage in substantial political campaign activity, or be organized or operated for the benefit of private interests. Any assets of such organizations must be dedicated to an exempt purpose, as specified under 501(c)(3), both in operation and upon dissolution.

Understanding tax-deductible donations to 501(c)(3) organizations also involves recognizing the different types within this classification, the nature of their tax-exempt status, and the rules for donor deductions. There are primarily three types:

• Public Charities: Public charities are what most people think of when they hear “charity.” This category includes churches, hospitals, schools, and broadly supported organizations like the American Red Cross or local animal shelter. They must meet the IRS’s public support test, which ensures that a substantial part of their funding comes from public donations and government grants. Donations to public charities are generally tax-deductible for donors up to 60% of their adjusted gross income (AGI) for cash donations and up to 30% for donations of appreciated assets like stocks.
• Private Foundations: In contrast to public charities, private foundations usually get funds from a single primary source, such as an individual, family, or corporation. This category includes both operating foundations, which run their own charitable programs, and nonoperating, grant-making foundations, which primarily donate funds to other charitable organizations. Examples include the Bill and Melinda Gates Foundation and the Ford Foundation. Contributions to private foundations are typically deductible, but the limits are lower compared to public charities: 30% of AGI for cash donations and 20% for appreciated assets.
• Private Operating Foundations: Private operating foundations are a subset of private foundations. These organizations devote most of their resources to the active conduct of their charitable activities rather than providing funding to other organizations. They must meet rigorous IRS tests to ensure active involvement in charitable work. In return, they receive certain benefits, including higher deductibility limits for donors, often similar to those for public charities. Donations to private operating foundations are generally tax-deductible up to 60% of their AGI for cash donations and fair market value up to 30% of AGI for donations of appreciated capital gain assets.

State-Level Tax Exemptions for Nonprofits in Pennsylvania

In Pennsylvania, nonprofits benefit from a range of state-specific tax advantages that complement federal tax exemptions. These provisions are designed to support the financial stability of nonprofits and enable them to allocate more resources toward their mission-driven activities.

• Sales and Use Tax Exemptions: Nonprofit organizations in Pennsylvania are generally exempt from state sales and use taxes. This exemption applies to most goods and services purchased by the nonprofit, substantially reducing the cost of operations and facilitating more extensive programmatic activities.
• Property Tax Exemptions: Real estate owned by nonprofits and used exclusively for charitable purposes is also exempt from Pennsylvania property taxes. This exemption can significantly decrease overhead expenses, allowing nonprofits to dedicate a larger portion of their budgets to direct community services and program development.

These state-level exemptions are crucial for nonprofits as they navigate the financial challenges associated with providing services and fulfilling their charitable missions. Understanding and leveraging these exemptions can lead to more effective and expanded operations within the state.

Nonprofits Do Pay Taxes

While nonprofits enjoy exemptions from income tax, they are not exempt from all forms of taxation. Here are some federal, state, and sometimes local taxes that still apply to nonprofit organizations:

• Federal Employment Taxes: Nonprofits are obligated to pay employment taxes on wages paid to employees. This includes Social Security and Medicare taxes, as well as Federal Unemployment Tax Act (FUTA) contributions.
• Unrelated Business Income Tax (UBIT): Nonprofits must pay taxes on income derived from business activities that are not substantially related to their exempt purposes. This ensures that nonprofits do not have an unfair competitive advantage over for-profit businesses in similar industries.
• Federal Excise Taxes: In specific instances, nonprofits are subject to federal excise taxes. These situations may include earning certain types of investment income, conducting sales of specific goods and services, or providing excessive benefits to insiders, which are meant to regulate activities that could conflict with a nonprofit’s exempt status.
• Customs Duties: Nonprofits engaging in international trade are required to pay customs duties on imported goods, aligning with regulations applicable to all entities involved in such activities.
• State and Local Taxes: At the state level, nonprofits may be exempt from income taxes but can still be liable for sales and use taxes unless specifically exempted by state law. Additionally, real estate taxes may apply, though many states provide exemptions for properties used exclusively for charitable purposes.

These tax obligations highlight the importance for nonprofits to maintain rigorous financial and operational compliance. Managing these tax responsibilities is crucial for maintaining good standing and ensuring the organization’s resources are used effectively in pursuit of its mission.

Conclusion

This exploration of nonprofit and tax-exempt statuses focused on the legal structures and operational requirements that define nonprofit entities and distinguish them from tax-exempt organizations. Rigorous compliance and filing obligations at both state and federal levels are essential for maintaining these statuses. This foundational knowledge is vital for effective governance and ensuring that nonprofits adhere to legal standards.

The next installment of this series, “What Every CPA Needs to Know about Federal Filing Requirements,” will cover the complexities surrounding the maintenance of tax-exempt status, including IRS filing and annual reporting requirements. Topics such as the public support test and UBIT will also be discussed, highlighting potential challenges that may impact nonprofits.

Your insights and feedback are invaluable, and I invite you to share your experiences, questions, or challenges related to the topics in this series.

The Essential Nonprofit Compliance Series

May 6 | What Every CPA Needs to Know about Nonprofit Status

June 3 | What Every CPA Needs to Know about Federal Filing Requirements

Monika Briggs, CPA, has a particular passion for nonprofit finance and compliance, actively enhancing her expertise while helping organizations navigate complex regulatory environments. She can be reached at monika.briggs@gmail.com.

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^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}