The Differences Between a 501(c)(3), 501(c)(4) and Other Tax Exemptions
Buried in the 74,608 pages of the United States Tax Codes are options.
Separated by just a few lines, which route you go to classify your nonprofit will have a big difference on what type of actions are legal and how you manage your finances. In fact, there are 29 different types of 501(c) organizations including cemetery companies, Teachers’ Retirement Fund Associations and Black Lung Benefit Trusts. These organizations are all exempt from the Federal Income Tax, and might also be exempt from state or local taxes.
You don’t need to know all of them, so here is an overview of some of the more common options and differences between each.
This classification is the most common for nonprofits. To fit into this category, an organization must fit into an exempt purpose as defined by the IRS. These include charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition and preventing cruelty to children or animals. While that’s quite the lengthy list, it’s not complete because the IRS breaks it down even more and defines what charitable means.
Restrictions: Any profits derived from the organization cannot benefit any director, officer or other individual. (This doesn’t mean that you cannot be paid for the work, quite the opposite, but unlike public corporations where directors or shareholders receive a split of the profits, a 501(c)(3) cannot issue any dividends.) Also, should the organization shut down, no individual may benefit from any distribution of assets. Lobbying, propaganda or other legislative activity must be kept insubstantial, which is generally interpreted as 10-20 percent of an organization’s activities.
Requirements: Each 501(c)(3) has to file a Form 990, which discloses the organization’s finances for the year. Often churches and schools fit into this category and they might have additional filing requirements.
Two types of organizations fit into this category: social welfare organizations and local associations of employees. Social welfare organizations can include homeowner associations and volunteer fire companies if they fit the exemptions. These organizations can engage in lobbying efforts if the causes coincide with the organization’s purpose.
The Supreme Court’s 2010 Citizens United decision allowed corporations and labor unions to register as a 501(c)(4) and, in turn, spend unlimited amounts of money on politics without disclosing their donors. As a result, the IRS was flooded with new applications for 501(c)(4) organizations.
Restrictions: Any earnings cannot benefit any individual shareholder or member. The organization cannot directly or indirectly participate in any political campaigns on behalf or in opposition to a candidate. It can engage in some political activity as long as that activity is not the primary purpose, however, those expenses might be subject to taxation.
Requirements: A 501(c)(4) organization is permitted to engage in lobbying to achieve its social welfare purpose. If an organization does engage in lobbying, it may be required to disclose how much of members’ dues are applicable to lobbying activities or pay a proxy tax.
This exemption covers business leagues, chambers of commerce, real estate boards, boards of trade and professional football leagues. (That’s how the NFL did it! At least until earlier this year.) A business league must strive to improve business conditions of an industry, but does not include a group composed of businesses that market a brand within an industry.
Restrictions: No part of the business league’s earnings may benefit any shareholder or individual. It may not oversee any profit-generating enterprises such as sales or money in exchange for goods. Also, contributions to a 501(c)(6) are not tax deductible as charitable contributions, but they may be deductible as a trade or business expense.
Requirements: A business league may solely be organized for lobbying without endangering its status. It may be required to notify its members how much of members’ dues are applicable to lobbying activities or pay a proxy tax. An organization may engage in some political activity as long as that activity is not the primary purpose, however, those expenses might be subject to taxation.
While the first three examples listed here are all found in the 501(c) section of the IRS code, the right fit for your organization might not be in the nonprofit world. To learn more about the possible fits in the for-profit world while still making a difference in the world, check out our article that examines benefit corporations, Certified B Corps and other for-profit set ups.
These tips should only serve as a starting point to get you to think about the different options that exist for your new potential organization. Consult with a tax attorney to fully understand the financial implications you could face, based on how you categorize your organization.
Or if you’re feeling adventurous, dive into the big book of the IRS tax code.