Employment Law 101: Tax-Exempt Status for Nonprofits

​This article is excerpted from Chapter 23 of The SHRM Essential Guide to Employment Law: A Handbook for HR Professionals, Managers, Businesses, and Organizations (SHRM, 2018), written by Charles H. Fleischer, Esq. 

A typical business corporation is formed by shareholders who invest their capital in the business with the expectation of earning a profit in the form of dividends or on the later sale of their stock. Shareholders hold ultimate power over the corporation by electing directors and by deciding issues that are fundamental to the corporation's existence, such as whether to change the company's capital structure or to merge with another company. The directors, in turn, manage the company by setting broad policies and appointing and overseeing corporate officers.

A nonprofit organization, on the other hand, is not formed to make a profit. Typically, it is a corporation organized under special provisions of state law that prohibit issuance of shares and the payment of dividends. Nonprofit organizations therefore have no shareholders, and they do not distribute earnings to owners. (Nonprofit organizations may have members who elect directors or trustees, but the members do not own the organization. In fact, nobody owns a nonprofit.)

· Part 1: Deductibility of Wages and Benefits
· Part 2: Employer Liability for Sexual Harassment
· Part 3: Tax-Exempt Status for Nonprofits

Although not organized to make a profit, nonprofit organizations are not required to operate at a loss. The point here is that any surplus of revenues over expenses must be retained or applied to nonprofit purposes and cannot be distributed to members of the nonprofit.

The term nonprofit is often used synonymously with tax-exempt. The two concepts, though related, are distinct. Nonprofit refers to the organization's purposes as expressed in its articles of incorporation and as governed by state law. Tax-exempt, on the other hand, means that the organization's net earnings are not subject to income tax. All tax-exempt organizations must be nonprofit, but just because an organization is nonprofit does not necessarily mean it qualifies for a tax exemption. Of course, the reason why an entity organizes as a nonprofit is usually to obtain tax-exempt status.

Section 5019(c) of the Internal Revenue Code contains a long list of terms under which organizations can qualify for tax-exempt status, including the following:

• Corporations organized and operated exclusively for religious, charitable, scientific, testing-for-public-safety, literary, or educational purposes, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual—so called 501(c)(3) organizations
• Civic leagues organized and operated exclusively for the promotion of social welfare
• Labor, agricultural, or horticultural organizations
• Business leagues, chambers of commerce, real estate boards, and boards of trade
• Recreational clubs

To achieve tax-exempt status, a nonprofit organization must submit an application to the Internal Revenue Service (IRS). If the IRS is satisfied that the organization is organized and is being operated for one of the exempt purposes listed on the Internal Revenue Code, it issues a determination letter to that effect. Exemption from state income taxes can usually be obtained on the basis of the IRS determination letter.

Another distinction that is often blurred has to do with the deductibility of contributions. While a tax-exempt organization pays no income tax, it does not necessarily follow that contributions to the organization qualify for a charitable deduction. Deductibility of contributions to 501(c)(3) organizations are governed by S170 of the Internal Revenue Code. Payments to other types of nonprofit organizations, such as business leagues, may qualify as trade or business expenses under S162 of the Internal Revenue Code.

With few exceptions, federal and state employment laws apply to nonprofits to the same extent that they apply to for-profit businesses. For example, nonprofits must withhold taxes from employee salaries, they must provide workers' compensation, they cannot discriminate (except in limited circumstances involving religious organizations), and they must provide safe workplaces.

Charles H. Fleischer, Esq., is admitted to practice law in Maryland and the District of Columbia and to the Bar of the United States Supreme Court and is a member of the law firm Oppenheimer, Fleischer, and Quiggle, P.C., of Bethesda, Maryland. He is also a member of the Montgomery County and Maryland State Bar Associations, the Barristers (inactive), and the Montgomery County Inns of Court (emeritus).

Please visit the SHRMStore to order a copy of The SHRM Essential Guide to Employment Law: A Handbook for HR Professionals, Managers, Businesses, and Organizations by Charles H. Fleischer, Esq.