501(c)(3) Tax-Exemption

A tax-exempt foundation is a perfect vehicle for engaging in activities that promote the public good. A public charity provides individuals and groups with a transparent structure that comes with significant tax benefits – to both the organization and its donors. A nonprofit organization is eligible for tax exemption as long as its purposes benefit the public good, and it does not engage in activities that are prohibited, such as lobbying and political activities. Tax-exempt organizations are exempt from paying federal income taxes on all revenue that is associated with its charitable purposes. Revenue includes proceeds from fundraising and solicitations, government and private grants, and earnings derived from the delivery of its services to the public. Likewise, individuals and companies that donate to a nonprofit foundation are eligible for a tax deduction – resulting in a win-win for the public.  

Purposes of a Tax-Exempt Entity

Public charities, educational institutions, and other organizations that qualify as tax-exempt under IRC 501(c)(3) are involved in a range of activities, though their focus on the public good is a common thread that underlies each of them. Examples of activities that serve the public interest include the advancement of social well-being such as a foster agency or work program for the disabled, protection of the environment, provision of health care, feeding and sheltering the homeless, and the promotion of culture and the arts – among numerous other types of services, programs, and initiatives that serve the public good. 

Pursuant to the Internal Revenue Code (IRC), a nonprofit may be organized to obtain 501(c)(3) tax-exempt status for the following purposes:

  • Charitable
  • Educational
  • Scientific
  • Religious
  • Testing for Public Safety
  • Literary
  • To Foster Amateur Sports 
  • Prevention of Cruelty to Children or Animals

Political Activities, Lobbying, and Propaganda are Prohibited

The tax code prohibits tax-exempt organizations from participating in the carrying on of propaganda, attempting to influence legislation, or participating in any political campaign for public office. 

Transparency

Public charities are required to operate in a transparent manner that involves the disclosure of their finances, their activities and the identity of the individuals that govern the organization. Not only is the IRS’s annual informational return for tax-exempt entities, the form 990, publicly available, but tax-exempt organizations are required to make certain documents available for public inspection and copying upon request. The documents that are available to the public include the organization’s application for tax-exemption (IRS form 1023), the governing documents, including the Certificate of Incorporation and bylaws, the exemption ruling letter issued by the IRS, and the annual IRS form 990. 

Private Benefit is Prohibited

It is important to understand that once funds are donated to a tax-exempt entity or a tax-exempt entity earns revenue from its services, its assets are ultimately dedicated to the public and do not belong to the company’s founders, employees or donors. If the company dissolves, all of its remaining assets must be transferred to another public charity. The prohibition on “private inurement,” as the tax code refers to it, includes paying a founder or employee compensation that is considered unreasonably high. If a private benefit is more than incidental, the nonprofit’s tax-exemption could be jeopardized and any company insiders that benefitted (and the board members who approved of the private inurement) could be liable for excise taxes and other penalties. 

Excess Benefits Transactions

If a tax-exempt organization provides a financial benefit (such as a salary) to a person who has the power to exercise substantial influence over its affairs, it may not exceed an amount that is reasonable in terms of similar payments to employees of charitable organizations located in the same region or industry. If the organization is found to have paid an amount that is higher than what other similarly-situated individuals receive for the same type of services, the organization has engaged in an excess benefit transaction. An excess benefits transaction requires reporting to the IRS, and excise taxes are assessed on the individuals who were paid more than is reasonable, and on any board member or officer who knowingly approves the transaction.

In order to ensure that the organization is not engaged in any type of excess benefits transactions, the board must approve the compensation and benefits of the chief executive of the organization based on a standard of “reasonableness.” The board determines the reasonableness of the proposed compensation by reviewing the compensation paid to three other similarly-situated executives that work for similar companies, both for-profit and nonprofit, that operate in the region. Alternatively, the board can commission an independent salary survey to confirm that the proposed salary is reasonable. Each year, the board must approve the compensation at a meeting, with the president or another chief executive on whose salary the board members are voting, recusing themselves from the vote if he or she also serves as a board member.  

Books and Records

The foundation’s officers, directors, trustees, and staff are charged with ensuring that the organization meets its ongoing compliance requirements in order to continue to maintain its tax-exempt status. Public foundations must maintain their books and records to document that they are in compliance with the various applicable tax laws and regulations and to track the sources of their revenue and expenses that are reported on the annual informational return (Form 990 or Form 990-EZ). Retention of a nonprofit’s records varies depending on the types of information and documents that are being held. For example, some records are permanently maintained, while others can be disposed of after three or four years. 

Nonprofits should maintain the application for recognition of tax-exempt status, IRS form 1023; the determination letter in which the IRS notifies the company of its approval of tax-exempt status; the Articles of Organization or Certificate of Incorporation; the bylaws; all board and company policies (such as the conflict of interest policies, whistleblower policy, and executive compensation policy); and all board of directors’ and members’ meeting minutes. If an organization has employees, employment tax records must be retained for a minimum period of four years after filing the fourth quarter for a given year.

Aside from tax reasons, there may be other reasons to maintain company records, such as for purposes of insurance, fundraising, or operating the company’s programs, which may require that records be kept longer than required by the IRS and New York State Department of Taxation and Finance.


Founding a public foundation can be complicated, though worthwhile and fulfilling, endeavor. There is a maze of compliance requirements that must be fulfilled in order to ensure that the foundation operates in accordance with the law. Through careful planning, the organization can successfully navigate applicable laws and regulations to preserve and protect its tax-exempt status. 

Claudia Pollak, Esq. is a nonprofit attorney based in New York.