The Difference Between Nonprofit and Tax-Exempt Status

3 min

The terminology used to describe trade and professional associations often generates much confusion. Consequently, it is useful to clarify two key terms. Associations are generally organized and operated as both nonprofit and tax-exempt entities. Nonprofit status refers to incorporation status under state law; tax-exempt status refers to federal income tax exemption under the Internal Revenue Code.

One who doesn't know otherwise might reasonably conclude that as nonprofit, tax-exempt entities, associations may not earn profits (realize more income than expenditures) and that they need not pay any taxes. Neither conclusion is correct.

Even though they are nonprofit organizations, associations are permitted to generate greater income than expenses and still retain their nonprofit status. As nonprofit organizations, what associations are barred from doing is distributing their net earnings to individuals who control the organizations. Similarly, they are barred from accumulating equity appreciation for private benefit. Nonprofit organizations have chosen to undertake programs to benefit members and the public rather than private individuals. Their earnings, therefore, must, by law, be dedicated to furthering the purposes for which they were organized. Nonprofit organizations have no shareholders and pay no dividends - all earnings are "reinvested" in the organization in furtherance of its nonprofit purposes.

Most associations are also tax-exempt entities, but they need not be. Because the requirements for federal income tax exemption are more stringent than those for nonprofit corporation status, there are some associations that are nonprofit corporations but do not qualify for exemption from federal income tax. However, these organizations are few and far between. Most nonprofit organizations qualify for federal income tax exemption under one of 25 subsections of Section 501(c) of the Internal Revenue Code. Most associations are tax-exempt under Sections 501(c)(3) or (c)(6), and a smaller number under Sections 501(c)(4) or (c)(5). In addition, some 501(c)(6) associations form related educational or charitable foundations exempt under Section 501(c)(3), along with other taxable and/or tax-exempt subsidiaries.

But what does tax exemption mean? Does it mean that an organization is exempt from all taxes? No. Tax-exempt status means that an organization is exempt from paying federal corporate income tax on income generated from activities that are substantially related to the purposes for which the entity was organized (i.e., to the purposes for which the organization was granted tax-exempt status). The organization must, however, pay federal corporate income tax (at standard corporate tax rates) on income which is unrelated to its tax-exempt purposes, called unrelated business income (UBI). Organizations that meet the requirements for federal tax exemption can generally rely on that status to exempt their income from state corporate income tax.

However, most associations that are tax-exempt do remain subject to a wide variety of other taxes, including federal payroll (Social Security, Medicare and unemployment) taxes, state and local unemployment taxes, real estate taxes, personal property taxes, sales and use taxes, franchise taxes, and taxes on lobbying activities, among others. Exemptions for certain state and local taxes are sometimes provided for certain types of philanthropic organizations, as well as certain colleges and universities, hospitals and other entities.

Associations are required to comply at all times with the strict guidelines for both tax exemption and nonprofit status in order to maintain their favored status under federal and state tax codes and state corporation laws.