ery often when speaking of corporations established for laudable purposes people incorrectly equate the word “nonprofit” with “charitable.” While this may be a distinction without a difference in casual discussions, when it comes to a federal tax return, the two are not synonymous. This misperception during the initial stages of planning and establishment of a nonprofit corporation can result in a costly mistake by organizers hoping to fund their activities with donations.
Specifically, although all charitable organizations are also nonprofit corporations, the converse is not always true. The difference is due to the fact that the term “nonprofit” derives from state law, whereas “charitable” is a term that has acquired a specific and technical meaning under the federal tax law.
State vs. Federal Law
Under Kentucky law, a “nonprofit corporation” is a “corporation no part of the income or profit of which is distributable to its members, directors or officers.” Nonprofit corporations may be organized for any lawful purpose or purposes and are not restricted to activities that are charitable.
However, the deduction in the federal tax code is solely for contributions or gifts which are “charitable.” Thus, while a nonprofit corporation is usually created for one or more worthy causes, a determination as to whether it will be organized and operated for charitable reasons is crucial if the funding plan relies on deductible public donations.
In order to be a deductible “charitable contribution,” the donation must be a contribution to a corporation “organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition…or for the prevention of cruelty to animals.” We’ll refer to these as “charitable purposes.” Section 501(c)(3) of the Internal Revenue Code recognizes these types of organizations (“501(c)(3)s”) as exempt from federal income tax. The three 501(c)(3)s that are most commonly known are educational, religious, and charitable organizations.
To satisfy the test above, the articles of organization must limit the organization’s purpose to one or more of the charitable purposes and not expressly empower the organization to engage in activities which do not further those purposes. The existence, therefore, of a substantial non-charitable purpose is fatal to qualification as a 501(c)(3). In addition, and common to nonprofit corporations, no part of the net earnings may “inure to the benefit of any private shareholder or individual,” nor can the corporation engage in lobbying or political campaigning.
The assets of the corporation must also be dedicated to the charitable purpose detailed in the articles of organization. For example, an organization does not meet the test if its articles or the law of the State in which it was created provide that the assets would, upon dissolution of the nonprofit, be distributed to its members or shareholders.
What is “charitable?”
Where this all may get confusing is in the regulations interpreting what is “charitable,” which describe the term to include:
- Relief of the poor and distressed or of the underprivileged;
- Advancement of religion;
- Advancement of education or science;
- Erection or maintenance of public buildings, monuments or works;
- Lessening of the burdens of government; and
- Promotion of social welfare by organizations designed to accomplish any of the above purposes, or (i) to lessen neighborhood tensions; (ii) to eliminate prejudice and discrimination; (iii) to defend human and civil rights secured by law; or (iv) to combat community deterioration and juvenile delinquency.
While the first four expressed purposes are readily understood, whether an organization’s objectives and goals are deemed to lessen the burdens of government, or to promote social welfare in a way that is charitable is less clear.
For example, before an organization can be classified as having the charitable purpose of lessening the burdens of government, it must be able to demonstrate that the State and/or a local government accepts the activities to be conducted as its, or their, own responsibility, and the government recognizes the organization as acting on its behalf. The fact that an organization is engaged in an activity that is sometimes undertaken by the government is insufficient to establish a burden of government.
Likewise, while an association or civic league that is operated for the promotion of social welfare may qualify for tax exemption under another section of the tax code, such an organization must also be considered as designed to accomplish charitable purposes in order to qualify as a 501(c)(3) organization, donations to which are tax deductible. Not all wholesome activities for the social improvement and welfare of the community are charitable; for example, providing free services to the public is not necessarily charitable unless, for example, it also is providing relief to the poor and distressed, or is advancing education or combatting community deterioration and juvenile delinquency.
Adding to the conundrum is that the Internal Revenue Service agrees the meaning of “charitable” is not to be construed as limited by these expressed purposes; rather, it recognizes there are other tax-exempt purposes that are charitable, many of which have been sanctioned by judicial decisions over the years.
The Complexities of Charitability
All this is to make the point that what is “charitable” is not always intuitive. Accordingly, if you are creating a nonprofit company and hope to fund it with tax-deductible donations from the public, it is important to realize that your non-profit organization must also qualify as a Section 501(c)(3) charitable organization in order for contributions to be tax-deductible. Therefore, during the initial stages of planning and establishment of a nonprofit corporation, attention to whether the purposes for which you are organizing meet the criteria for what is “charitable” under federal tax law, as well as being not-for-profit, is essential if the goal is for the organization to be funded in whole, or in part, through public contributions.
Finally, please note that the focus of this blog is to outline what it means to be organized for a charitable purpose or purposes under the federal income tax law. It is also imperative that your organization is operated for a charitable purpose or purposes in order to qualify as a Section 501(c)(3) organization. Further, your organization will not be regarded as satisfying these tests unless it serves a public, rather than a private, interest.