A food bank sells advertising space in its newsletter. The charity keeps its exemption, but that advertising income is taxed at corporate rates. Exempt does not mean untaxed.
Tax-exempt status is a privilege the law grants. An organization doesn't start out exempt. It qualifies only if it fits one of the categories listed in the numbered paragraphs of IRC §501(c), and it stays exempt only while it keeps meeting that paragraph's conditions.
These are the §501(c) categories tested most often. The last column tells you whether a donor can deduct a contribution to that kind of organization:
To qualify under §501(c)(3), an organization must pass two tests. The organizational test looks at what its governing document says. The operational test looks at what the organization actually does. Passing only one of them isn't enough.
- Organizational test: the articles must limit the organization's purposes to exempt purposes and must not give it the power to carry on substantial activities that serve other purposes.
- Operational test: the organization must engage primarily in activities that accomplish its exempt purposes.
Common mistakes
- Netting separate unrelated businesses. Candidates combine a $19,000 cafe profit with an $8,000 loss to reach $11,000. Section 512(a)(6) forbids this, because each unrelated trade or business stands alone.
- Taking the $1,000 specific deduction per activity. Even with three unrelated businesses, the deduction is still $1,000 in total, not $3,000.
- Testing the wrong figure against $1,000. The $1,000 trigger for filing Form 990-T is measured on gross unrelated business income, not on net income after expenses.
Bottom line
- §501(c)(3) requires both an organizational test in the articles and an operational test in actual conduct; inurement of any amount is fatal.
- Lobbying must not be substantial; political campaign intervention is absolutely prohibited.
- Form 1023 filed within 27 months of the end of the month of formation backdates exemption to formation; later filings run from the postmark.
- Form 1023-EZ requires gross receipts of $50,000 or less and assets of $250,000 or less; Form 1024 covers most non-(c)(3) categories.
Exam shortcut
Run UBTI stems through the three prongs in order and stop at the first failure. "Once a year," "annual bazaar," or "one weekend" kills the regularly-carried-on prong. "Volunteers ran it," "donated merchandise," "hospital cafeteria for patients," or "sponsorship with mere acknowledgment" hits a modification. "Rent" means ask two questions: real or personal property, and is there acquisition indebtedness.
The full lesson (about 3,513 words, 23 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2
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