To the chagrin of many, taxes are a standard obligation for most businesses; however, the federal government does grant certain exceptions. Organizations that receive these exceptions are considered tax-exempt, meaning they are exempt from paying taxes on business income. A tax-exempt business can also qualify for other benefits, such as tax-deductible donations, depending on its IRS status.
What you’ll learn
What you’ll learn
Key takeaways
- An IRS tax exemption can relieve a business from federal income tax obligations and may have local and state income tax benefits, depending on state tax laws
- To apply for a tax exemption certificate, a business must submit detailed documentation about its structure and purpose
- In most cases, tax-exempt organizations must maintain their status with annual information returns
That said, the Internal Revenue Service (IRS) doesn’t automatically designate a business as tax-exempt. It’s up to a business’s owners to understand eligibility rules. In this article, you’ll learn how to determine whether your business might be eligible, as well as what tax-exempt means for a business and how to apply.
What is a tax-exempt business?
A tax-exempt business is any organization that does not owe income tax to the IRS. The exemption applies explicitly to federal tax, though most states honor tax-exempt status. Those states may also exempt qualifying businesses from property and sales tax.
What are the requirements for a tax-exempt business?
Businesses may be tax-exempt if they use their resources to serve a purpose, rather than to earn a profit. Commonly exempt organization types include:
- Charitable entities
- Churches and other religious organizations
- Private grant-issuing foundations
- Political organizations
- Other not-for-profit groups, as defined under U.S. Internal Revenue Code Section 501, subsection (c)
You may be familiar with 501(c)(3), a designation that people associate with charitable organizations. The IRS also includes qualifying religious, scientific, educational, literary, and public safety organizations in this category. For example, your local food bank, animal shelter, or Boys and Girls Club is likely a 501(c)(3).
Section 501(c) also includes more than two dozen other organization types that can be tax-exempt, assuming they meet specific requirements. These include:
- Social welfare organizations
- Labor and agricultural groups
- State-chartered credit unions
- Mutual insurance companies
- Business leagues, such as a Chamber of Commerce
- Social and recreational clubs, such as soccer leagues
There’s a lot to keep track of when it comes to qualifying for and maintaining tax-exempt status, so we also put together a quick table to help you skim the essentials at a glance.
| Topic | What it means | What’s often overlooked |
| Who qualifies | Organizations serving a public, charitable, religious, scientific, or educational purpose (various 501(c) types). | Nonprofit status alone does not equal federal tax-exempt status. Must apply through the IRS. |
| Requirements | Must be formally organized (trust, LLC, corporation) with Articles of Incorporation stating that no earnings benefit private individuals. | Exempt organizations generally can’t devote substantial resources to lobbying or political activities. |
| How to apply | Submit the appropriate IRS application (Form 1023, 1024, or others) within 27 months of forming the organization. | Filing late can affect if tax-exempt status is retroactive to your date of incorporation. |
| What it covers | Exemption from federal income tax on related business income; many states extend exemptions to property or sales tax. | Organizations may still owe unrelated business income tax and must still pay payroll taxes for employees. |
| Maintaining status | Most must file an annual information return (Form 990 series). | Missing filings can lead to penalties or automatic loss of exempt status. |
| Record-keeping | Must track revenue, assets, expenses, compensation, and mission-related activities. | Manual recordkeeping increases compliance risk — nonprofit payroll software can help maintain clean records. |
Specific qualifications depend on your business type, but some requirements apply to all aspiring tax-exempt groups. Let’s take a look at those next.
Key requirements to qualify as a tax-exempt business
Before applying for tax-exempt status, you’ll need to organize formally as a trust, association, limited liability company, or corporation. Part of this process involves creating Articles of Incorporation, which describe the purpose of your business in detail.
Keep in mind that Uncle Sam will examine this language closely to determine if you qualify for tax-exempt status. We point this out because it could be worth using the IRS-provided Articles of Incorporation template, which clearly specifies that no amount of revenue will benefit a private individual.
Exempt businesses also may not allocate substantial resources to influencing legislation or elections. Some entities, including 501(c)(4)s, may engage in political activity, but it cannot be their defining purpose.
The final qualifying step is to register your organization as a nonprofit at the state level. This step is not necessarily a requirement for claiming your tax-exempt status, but it may be a state requirement. It also strengthens your application by confirming your public-good mission.
Moving on, it’s time to understand what applying for this status entails.
How to apply for tax-exempt status
The first step in the application process is to gather all necessary paperwork, including incorporation documents and state registration. You’ll also need to obtain an employer ID number.
The IRS recommends that nonprofit organizations apply within 27 months of organizing as a business. Doing so qualifies you to claim nonprofit status starting from your date of incorporation. Otherwise, your exemption will be valid on the date of application, not on the date you organized, unless you qualify for a retroactive exemption.
To begin the application, visit the IRS website to determine which type of tax-exempt status to pursue. Avoid guessing your classification, as this can result in submitting the wrong documents. Check the requirements for 501(c)(3) and 501(c)(4) organizations, each of which has its own required application documents. Otherwise, you will complete IRS Form 1024.
Take care to read the instructions for your relevant business tax-exempt form in detail. It can be tempting to jump straight into any tax form, given their length, but any missed or incorrect information can delay your approval. So what do business owners sometimes miss when understanding how this status works?
Common misconceptions about tax-exempt businesses
Tax exemption is more involved than many small business owners assume. Acting on these assumptions can lead to problems later on, so it’s best to dispel these two misconceptions immediately:
- All nonprofits are tax-exempt: Nonprofit status is a state designation. It may qualify a business for certain state-level tax benefits, including sales, property, and income tax exemptions. However, to be tax-exempt at the federal level, you must apply through the IRS.
- Tax-exempt means no taxes: Tax-exempt status only excuses you from paying income tax on normal business income. An exempt business may still incur state and local taxes, depending on state tax laws. Exempt organizations must also pay unrelated business income tax on any revenue not related to the business’s purpose. And finally, nonprofits with employees will be subject to payroll taxes.
You’ll want to understand all the qualification rules, as well as the benefits and drawbacks of tax-exempt status.
Benefits and limitations of being tax-exempt
Freedom from federal income tax is the most obvious advantage of being a tax-exempt entity, but it isn’t the only benefit. State and local tax exemptions can also save a business a significant amount of money.
Many tax-exempt organizations also enjoy fundraising benefits. Most 501(c)(3) entities and some 501(c)(4) organizations allow donors to deduct the value of their donations from their individual income taxes. Consult a tax professional if you plan to offer your supporters this tax deduction opportunity.
To qualify for these privileges, tax-exempt organizations must accept certain limitations. The strictest requirements apply to 501(c)(3) organizations, which cannot:
- Serve any private interest
- Use income to benefit individuals directly associated with the organization, including board members
- Devote substantial resources to influence lawmaking
- Actively help or work against a candidate for office
- Participate in activities that violate public policy
Some of these limitations may apply to other 501(c) organizations. If you run any such organization, you’re responsible for learning and following the applicable compliance rules.
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Maintaining compliance as a tax-exempt business
To maintain their status, most tax-exempt businesses must file an annual information return with the IRS. This involves completing Form 990, using the correct version based on the business’s receipts or assets.
To complete most versions of this form, including the full Form 990 and Form 990-EZ, you’ll need detailed information about your organization’s revenue, assets, expenses, employee compensation, and service accomplishments. Organizations must also make their returns and exemption applications available to the public upon request.
Failure to comply with any tax-exempt business requirement can result in penalties and could cause you to lose your tax-exempt status. The best way to avoid these penalties is to understand the rules in detail and keep meticulous records, especially regarding payroll.
Tools and strategies to manage tax-exempt business obligations
Your business’s tax-exempt status depends on the accuracy of your records. Manual record-keeping is vulnerable to error, so it’s essential to have high-quality payroll and accounting software as part of your workflow.
The right software streamlines nonprofit payroll and automates key steps, including employee benefits and tax requirements. It keeps records of all your payroll activity, so you don’t have to go hunting for information when annual report time comes around.
Simplicity is key, so look for something that handles compliance and non-compliance-related details. You don’t want to keep your exempt vs. non-exempt employee classification and compensation details in separate places.
Simplify compliance and payroll management for tax-exempt businesses
Now that you know more about what businesses are tax-exempt and how to get a tax exemption certificate for a business, you’re ready to start thinking about paperwork. The first step is to get your payroll in order, and OnPay is here to help. Whether you pay self-employment tax or need help with small business payroll taxes for a team, OnPay automates the critical steps, so you can focus on running a thriving tax-exempt organization.
Explore OnPay today and discover a simpler way to run payroll, and our team is here to answer any of your questions!
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Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.