A nonprofit organization, or NPO, is a legal entity formed for a purpose other than generating profit for its owners or members. Any surplus revenue an NPO brings in has to stay inside the organization and go toward its mission or operations; it cannot be paid out to directors, officers, or members as a share of profits. Federal tax law recognizes more than two dozen categories of nonprofit under 26 U.S.C. ยง 501, and the category an organization falls into determines what it can do with donations, how much it can lobby, and whether contributors can claim a tax deduction.1Office of the Law Revision Counsel. 26 USC 501 – Exemption From Tax on Corporations, Certain Trusts, Etc.
What Makes an Organization a Nonprofit
The line between a nonprofit and a for-profit business is what happens to leftover money. A for-profit company can pay its profits to shareholders as dividends. A nonprofit cannot. This concept, sometimes called the non-distribution constraint, is what makes the whole structure work: it signals to donors, regulators, and the public that the organization exists to serve its stated purpose rather than enrich the people who run it.
That does not mean a nonprofit has to lose money. Nonprofits can and often do bring in more than they spend. The restriction is on where the surplus goes. Reasonable salaries and benefits for work actually performed are fine. Bonuses pegged to fundraising revenue or sweetheart deals with insiders are not.
Every nonprofit is governed by a board of directors (sometimes called trustees) with legal duties to the organization. Board members owe a duty of care, meaning they must pay attention and make informed decisions. They owe a duty of loyalty, meaning the organization’s interests come before their own. And they owe a duty of obedience, meaning programs and spending must align with the founding mission. When boards ignore these responsibilities, the consequences range from IRS penalties to personal liability to dissolution by state regulators.
The Main Types of Tax-Exempt Nonprofits
Most nonprofits people encounter fall into one of three categories under section 501(c).
501(c)(3): Charitable, Educational, and Religious Organizations
The 501(c)(3) designation is the most common and the most restrictive. It covers organizations operated for religious, charitable, scientific, literary, or educational purposes, among others.1Office of the Law Revision Counsel. 26 USC 501 – Exemption From Tax on Corporations, Certain Trusts, Etc. In exchange for those restrictions, donations to 501(c)(3) organizations are tax-deductible for the donor, which makes fundraising significantly easier.
Within this category, the IRS draws a further line between public charities and private foundations. A public charity draws its support broadly, typically passing what the IRS calls a “public support test” by receiving at least one-third of its funding from government grants, public contributions, or program revenue.2Internal Revenue Service. Form 990, Schedules A and B: Public Charity Support Test A private foundation, by contrast, usually gets its money from a single family or corporation and funds other organizations through grants. Private foundations face stricter rules on self-dealing and must distribute a minimum percentage of their assets each year.
501(c)(4): Social Welfare Organizations
Social welfare organizations promote community well-being through civic or political engagement. They can lobby legislators without meaningful limit and participate in some political activities, as long as political campaign work isn’t their primary purpose. Donations to a 501(c)(4) are not tax-deductible for the donor. Many advocacy and issue-focused groups choose this structure because it gives them room to engage in the political process without the tight lobbying caps that apply to charities.
501(c)(6): Business Leagues and Trade Associations
Chambers of commerce, trade associations, and professional leagues organize under 501(c)(6) to promote an entire industry or profession rather than any single company. These groups focus on networking, standard-setting, and industry advocacy. Like 501(c)(4) groups, they can lobby, but contributions are not tax-deductible as charitable gifts. Members can sometimes deduct dues as a business expense, though the portion allocable to lobbying generally is not deductible.
What Donors Can and Cannot Deduct
The 501(c)(3) designation matters so much for fundraising because it is the main category whose contributions qualify as tax-deductible charitable gifts. Contributions to 501(c)(4) and 501(c)(6) organizations generally do not.
For donors who itemize, cash contributions to public charities can be deducted up to 60 percent of adjusted gross income (AGI).3Office of the Law Revision Counsel. 26 USC 170 – Charitable, Etc., Contributions and Gifts Donations of appreciated property, such as stock, are generally limited to 30 percent of AGI. Contributions to private foundations face a lower cap of 30 percent for cash and 20 percent for property. Amounts exceeding these limits can be carried forward for up to five years. Changes taking effect in 2026 add a new floor for itemizers (only charitable contributions exceeding 0.5 percent of AGI are deductible) and a modest deduction for non-itemizers of up to $1,000 in cash contributions ($2,000 for married couples filing jointly).
For any single contribution of $250 or more, the donor needs a written acknowledgment from the organization to claim the deduction. The acknowledgment must include the organization’s name, the amount of any cash gift, a description (but not a value) of any non-cash gift, and a statement about whether the organization provided any goods or services in return.4Internal Revenue Service. Charitable Contributions: Written Acknowledgments If the organization did provide something in return, like a gala dinner or merchandise, the acknowledgment must include a good-faith estimate of its value.
Lobbying and Political Activity Limits
The rules on political involvement differ sharply by classification, and getting them wrong can be fatal to a nonprofit’s tax-exempt status.
For 501(c)(3) charities, the ban on political campaign activity is absolute. An organization that endorses a candidate, donates to a campaign, or publishes statements for or against someone running for office faces automatic loss of its tax-exempt status. There is no warning, no sliding scale. This is the one line a charity cannot cross.
Lobbying on legislation is different. A 501(c)(3) can do some lobbying, but it cannot be a “substantial part” of its activities. Because that standard is vague, the IRS offers an alternative called the 501(h) election, which gives organizations clear dollar limits on lobbying expenditures tied to their exempt-purpose spending. Grass-roots lobbying, which asks the public to contact legislators, is capped at one-quarter of the overall lobbying limit, and exceeding these limits over a four-year averaging period can result in loss of exempt status.5eCFR. 26 CFR 1.501(h)-3 – Lobbying or Grass Roots Expenditures Normally in Excess of Ceiling Amount
Organizations classified under 501(c)(4) can lobby without limit and can participate in political campaigns, provided political activity is not their primary purpose. That flexibility is the main reason many advocacy organizations choose the 501(c)(4) structure despite losing the donor deduction.
Financial Rules That Apply to Every Nonprofit
Tax-exempt status comes with ongoing constraints on how a nonprofit can use its money and treat its people. Some of these rules trip up even well-meaning boards.
No Private Inurement
No part of a nonprofit’s earnings can benefit insiders beyond fair compensation for actual work. This prohibition, called the private inurement rule, applies to board members, officers, key employees, and anyone with substantial influence over the organization.
When an insider receives an “excess benefit,” the IRS often uses intermediate sanctions instead of revoking exempt status outright: an excise tax equal to 25 percent of the excess benefit, paid by the person who received it. Managers who knowingly approved the transaction owe a separate tax of 10 percent. If the insider doesn’t return the excess benefit within the statutory correction period, the penalty jumps to 200 percent of the excess amount.6Office of the Law Revision Counsel. 26 USC 4958 – Taxes on Excess Benefit Transactions An above-market salary, a personal loan from the organization’s funds, or a no-bid contract with a board member’s company can all trigger these penalties.
The IRS strongly recommends that every nonprofit adopt a written conflict-of-interest policy, and Form 990 asks whether one exists. A well-functioning policy also helps boards document executive compensation decisions, which is the single best defense if the IRS later questions whether salaries are reasonable.7Internal Revenue Service. Tax-Exempt Health Care Organizations Community Board and Conflicts of Interest Policy
Unrelated Business Income Tax
Nonprofits can earn money from commercial activities, but if those activities are regularly conducted and not substantially related to the organization’s exempt purpose, the income is taxable. A nonprofit hospital running a cafeteria for patients and staff is related. The same hospital operating an unrelated parking garage open to the general public likely is not. Any organization with $1,000 or more in gross income from unrelated business activities must file Form 990-T and pay the applicable tax.8Internal Revenue Service. Unrelated Business Income Tax
Employment Taxes and Volunteers
Nonprofits with employees must withhold and pay federal income tax and FICA (Social Security and Medicare) like any other employer. Organizations with 501(c)(3) status are exempt from the Federal Unemployment Tax Act (FUTA); the exemption is automatic and cannot be waived. Tax-exempt organizations under other subsections, such as 501(c)(4) or 501(c)(6), do not get this benefit.9Internal Revenue Service. Exempt Organizations: What Are Employment Taxes
Volunteers are essential to most nonprofits, but misclassifying a worker as a volunteer when they are actually an employee can create serious liability under the Fair Labor Standards Act. A true volunteer serves freely, without expectation of compensation, for humanitarian or civic purposes. Someone who receives a regular stipend tied to hours worked, displaces a paid employee, or performs the same duties they are hired to do in their regular job is likely an employee entitled to minimum wage and overtime protections.10U.S. Department of Labor. Fact Sheet 14A: Non-Profit Organizations and the Fair Labor Standards Act (FLSA)
Annual Filings and Public Disclosure
Tax-exempt status is not a one-time achievement. Most tax-exempt organizations must file an annual information return with the IRS.11Office of the Law Revision Counsel. 26 USC 6033 – Returns by Exempt Organizations The filing obligation comes in three tiers. The smallest organizations, those with annual gross receipts normally at or below $50,000, file Form 990-N, an electronic notice sometimes called an e-Postcard.12Internal Revenue Service. Annual Electronic Filing Requirement for Small Exempt Organizations – Form 990-N (e-Postcard) Mid-size organizations can file the shorter Form 990-EZ, while larger organizations file the full Form 990, which covers executive compensation, program accomplishments, revenue breakdowns, balance sheet data, and governance practices. Churches and certain religious organizations are exempt from the annual filing requirement.
An organization that fails to file its required annual return for three consecutive years automatically loses its tax-exempt status. This happens by operation of law, with no hearing and no grace period. Reinstatement requires filing a new exemption application, paying the full user fee again, and potentially covering back taxes on income earned while the status was revoked. Small organizations that only need to file the e-Postcard are especially vulnerable, because the requirement seems trivial and is easy to forget.
Transparency is not optional either. Federal law requires every tax-exempt organization to make its three most recent annual returns available for public inspection at its principal office during regular business hours, along with its original exemption application.13Office of the Law Revision Counsel. 26 USC 6104 – Publicity of Information Required From Certain Exempt Organizations and Certain Trusts Most organizations satisfy this by posting their returns on their own websites or through platforms like GuideStar.
Beyond federal obligations, most states require nonprofits to register before soliciting donations from their residents. These charitable solicitation laws vary widely in fees, financial reporting, and rules for using paid fundraisers.14Internal Revenue Service. Charitable Solicitation – State Requirements An organization that fundraises online typically triggers registration requirements in every state where donors reside, which can mean registering in dozens of states.
How to Form a Nonprofit
Creating a nonprofit involves both state and federal steps, and the order matters. Incorporate at the state level first, then apply to the IRS for tax-exempt status.
Start by filing articles of incorporation with your state’s secretary of state or equivalent office. Filing fees vary by state but commonly fall in the range of $50 to $100. The articles must include a purpose clause stating the organization is formed for purposes recognized under Section 501(c)(3), and a dissolution clause specifying that any remaining assets will go to another tax-exempt organization or to a government entity for public purposes if the nonprofit shuts down.15Internal Revenue Service. Suggested Language for Corporations and Associations (per Publication 557) Skip this language and the IRS will reject the application. You will also need bylaws covering how board members are selected and removed, officer roles, meeting frequency, quorum, and conflict-of-interest procedures.
Before applying to the IRS, obtain an Employer Identification Number (EIN), which you can get online at no cost.16Internal Revenue Service. Obtaining an Employer Identification Number for an Exempt Organization Then file either Form 1023 (the full application) or Form 1023-EZ (the streamlined version). The streamlined form is available to organizations projecting annual gross receipts of $50,000 or less and total assets of $250,000 or less.17Internal Revenue Service. Instructions for Form 1023-EZ
The filing fees differ: $275 for Form 1023-EZ and $600 for the full Form 1023.18Internal Revenue Service. Form 1023 and 1023-EZ: Amount of User Fee So do processing times. As of early 2026, the IRS issues 80 percent of Form 1023-EZ determinations within about 22 days, while 80 percent of full Form 1023 applications are processed within roughly 191 days.19Internal Revenue Service. Where’s My Application for Tax-Exempt Status? You generally cannot promise donors a tax deduction until the IRS approves the application, though approval usually retroacts to the date of incorporation if you file within 27 months.
How a Nonprofit Is Dissolved
When a nonprofit shuts down, it cannot simply distribute its remaining assets to board members or staff. A 501(c)(3) must transfer leftover assets to another 501(c)(3) or to a government entity for a public purpose, a requirement that should already be baked into the articles of incorporation from day one.
On the federal side, the organization must file a final Form 990 with the “Final return/terminated” box checked and attach Schedule N, which requires a detailed accounting of every asset distributed: what, to whom, when, and at what fair market value.20Internal Revenue Service. Termination of an Exempt Organization Schedule N also asks whether any officer, director, or key employee of the dissolving organization is involved with the entity receiving the assets, which is one more way the IRS watches for self-dealing on the way out the door. Most states require a formal dissolution filing with the secretary of state, final state tax returns, and cancellation of any charitable solicitation registrations. Skipping the state steps can leave directors personally exposed to ongoing liabilities long after the organization stops operating.