A nonprofit hospital runs a gift shop that brings in $600,000. A civic league asks donors to write checks "for the cause." A private family foundation holds $50 million in endowment assets. None of them owe federal income tax on their core mission, but each one faces a different filing form, a different set of restrictions, and a different way to lose its exempt status. The exam tests whether you can tell them apart.
A tax-exempt organization pays no federal income tax on revenue from activities related to its exempt purpose. But exemption is not automatic, and not every "nonprofit" is the same. The organization must be organized and operated for one of the purposes Congress recognized in §501(c). The four categories tested most often:
- §501(c)(3): charitable, religious, educational, scientific, literary. Contributions are deductible to the donor. The strictest rules apply here.
- §501(c)(4): social welfare organizations and civic leagues. The org pays no tax, but contributions are NOT deductible to the donor.
Common mistakes
- Treating §501(c)(4) contributions as deductible. Only §501(c)(3) contributions give the donor a charitable deduction. Donations to social welfare organizations, business leagues, and social clubs are NOT deductible as charitable contributions. The donor pays no income tax to the org-side, but Schedule A gets nothing.
- Confusing lobbying and political campaign activity. §501(c)(3) organizations can engage in limited lobbying. Political campaign activity is absolutely prohibited, zero tolerance. The exam loves presenting a nonprofit that endorses a candidate and asking about consequences. Answer: potential loss of exempt status.
- Including passive investment income in UBIT. Dividends, interest, royalties, real property rents, and capital gains are all excluded from UBIT. The trap is applying the 21% rate to a large endowment's dividend income. Answer is zero.
Bottom line
- §501(c)(3) is the only category that gives donors a charitable deduction. (c)(4) social welfare, (c)(6) trade associations, and (c)(7) social clubs do not.
- (c)(3) status requires both the organizational test (governing documents) and the operational test (actual activities), plus no private inurement, no substantial lobbying, and zero political campaign activity.
- File Form 1023 (or 1023-EZ for small orgs) for (c)(3) recognition. File Form 1024 for most other (c) categories. Churches are automatically exempt.
- Form 990 thresholds: 990-N (gross receipts ≤$50K), 990-EZ ($50K-$200K and assets <$500K), 990 (>$200K receipts OR ≥$500K assets), 990-PF (all private foundations). Three consecutive years of non-filing equals automatic revocation.
Exam shortcut
For category questions, ask one thing first: does the donor get a deduction? If yes, it's (c)(3). If no, it's everything else. For UBIT, run the three-part test and immediately exclude passive investment income. The favorite trap is rents from personal property: real property rents are excluded, but equipment and furniture rents are not. For private foundations, remember: 1.39% on net investment income, 5% mandatory distribution, six excise taxes total.
The full lesson (about 2,692 words, 18 min read) adds 1 worked example, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- V.F1
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