Avoiding Pitfalls When Applying for Tax-exempt Status

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While many new Main Street organizations understand the importance of securing 501(c)(3) tax-exempt status from the Internal Revenue Service(IRS), they may not recognize all of the complexities of achieving this designation.  Applying to become a 501(c)3 nonprofit charitable organization is a complex process with many nuances and potential pitfalls. The most common questions the IRS has about Main Street program applications seem to revolve around two points:

  • A confusion at the IRS between Main Street organizations and chambers of commerce/retail merchants associations; and
  • The use of the term “economic development,” which the IRS often considers to involve providing financial and subsidies that benefit a class of businesses (often industrial in nature).

Essentially, the process of seeking 501(c)3 status begins with the organization’s incorporation. The articles of incorporation must use 501(c)3-appropriate language and reflect that the organization intends to operate as a 501c3 nonprofit organization in accordance with IRS regulations. In addition, the organization’s statement of purpose must reflect the ways the organization will function according to the IRS’s categories of charitable 501(c)3 nonprofit organizations. This means clearly outlining Main Street activities in approved charitable purpose categories such as:

  • Education: teaching the public about best practices, community organization, revitalization techniques, the benefits of downtown, conservation, going “green.”
  • Lessening the burdens of government: community cleanups, managing a farmers market, raising funds for public improvement projects that government cannot afford, combating community deterioration;
  • Beautification;
  • Charitable economic development;
  • Arts and cultural activities;, and
  • Historic preservation.

Because the term “economic development” can cause confusion about whether the organization truly is operating with charitable intent, the phase “community development” can be used in the articles of incorporation, or the organization can describe its efforts to improve the Main Street economy as “combating the underlying causes of economic deterioration” in the Main Street district. 

A 501(c)3 is allowed by the IRS to conduct economic development activities as long as they are directed toward a charitable purpose, such as assisting a disadvantaged group with employment opportunities, addressing blight, lessening the burdens of government, or supporting another charitable activity such as historic preservation. The delivery of business assistance (providing advice, information, or workshops for example) can also be described as educational, which is an allowed c3 charitable purpose.

The application for 501(c)(3) status (Form 1023) must be carefully written to avoid IRS “red flag” language that will cause the agency to deny c3 status, namely an excess of festivals, mention of retail or business promotions, and activities that appear to benefit a specific group of individuals instead of demonstrating benefit to the general public as a public charity must. If the organization plans to conduct these types of “red flag” activities, they must be described in a way that stresses how they meet the charitable purposes of the organization.  For example, the purpose of conducting a community heritage festival could be described as “educating the public about community history and cultural traditions,” and the phrase “educating the public about the features of the historic Main Street district” can be used generally to describe a variety of events.

Another common problem for Main Street organizations trying to attain 501c3 tax-exempt status is that the organization looks too much like a business association that benefits a narrow group of interests, namely downtown business and property owners. To be approved as a 501(c)3 public charity, the group’s activities must provide benefit to the general public, not just to a select few.  It is important for the application to describe how Main Street’s activities are open and accessible to a variety of participants, not just a select group, such as members or those who make a financial contribution to the organization.  Any activities that are open to the general public should be highlighted.  If the organization needs to limit its activities to a smaller group—for example, limiting architectural assistance to owners of downtown property—it can recall its mission and explain that such services are limited because of limitations on funding and/or the organization’s capacity to deliver such assistance to a wider group. 

Other Types of Nonprofits

There are many other types of nonprofit organizations considered by the IRS to be exempt from federal income taxes. If a Main Street organization’s application for 501(c)(3) status is not appropriately written, then the IRS will often suggest that the applicant might be better suited to a 501(c)(4) or 501(c)(6) tax-exempt classification:

To be tax-exempt as a 501(c)(4), an organization must be organized as not-for-profit and must be operated exclusively to promote social welfare. The organization must operate primarily to further the common good and general welfare of the people of the community, such as by bringing about civic betterment and social improvements.

Section 501(c)(6) of the Internal Revenue Code provides for federal tax exemption of business leagues, chambers of commerce, real estate boards, and boards of trade, which are not organized for profit. Like a c3, no part of the net earnings of the corporation should inure to the benefit of any private individual. A business league is an association of persons having some common business interest, the purpose of which is to promote that interest, not to engage in a regular for-profit business. Chambers of commerce and boards of trade direct their efforts at promoting the common economic interests of all commercial enterprises in a trade or community.

Neither 501(c)(4) or 501(c)(6) status is ideal for Main Street organizations. While c4 and c6 statuses also provide an exemption from federal income taxes for the nonprofit organization, without c3 status, individuals who donate to the Main Street organization will not be able to take a tax deduction on their personal income taxes for their donations, nor will the organization be able to apply for many foundation or government grants, which are often awarded exclusively to organizations with 501(c)(3) status.

Anytime one deals with the IRS—especially in gaining approval for 501(c)(3) tax-exempt status, the process can be complex and time-consuming. While many start-up Main Street organizations have limited budgets, it is well worth the investment of funds to consult with a qualified professional who can help the organization understand and obtain its federal tax-exempt status.

NOTE: This article is not intended to represent legal or financial advice from the National Trust for Historic Preservation, ReSurge, Inc.®, or Stephanie Redman. Main Street organizations are strongly encouraged to contact a qualified nonprofit attorney or Certified Public Accountant for such advice.  For recommendations of qualified professionals, contact your state or citywide Main Street coordinator and/or ask other Main Street organizations for names of experienced professionals who have assisted them with achieving tax-exempt status.

Additional Resources

The Life Cycle of an Exempt Organization—a must-read for any group considering applying for 501c3, c4, or c6 tax-exempt status. Skip directly to http://www.irs.gov/charities/charitable/article/0,,id=122670,00.html if you know you want to attain exemption as a 501(c)(3) public charity.

Getting a Green Light from the IRS

Applying for 501c3 Tax Exempt Status

Frequently Asked Questions about Applying for Tax Exemption