Federal Exemption Doesn’t Mean Tax Free: The Reality of State Taxes

A common misconception I’ve started to come across is the belief that receiving a 501(c)(3) status means an organization is no longer responsible for any taxes. Which couldn’t be further from the truth.

I think alot of the confusion comes from the fact that so many words in the nonprofit/exempt org’s space tend to be used interchangeably. The word “nonprofit” is often used as a synonym for a 501(c)(3). So  people tend to think once they’ve gotten that tax exemption status they’re off scott free.

But a “nonprofit” entity is defined state by state. And it’s that entity that can then file for exemption from federal income tax. But that has nothing to do with the State taxes organization’s may still be required to pay like state corporate income tax, franchise taxes, sales taxes, excise taxes, hotel and occupancy taxes and property taxes to name a few. There are even some States that have their own unrelated business income tax.


What’s the Big Deal?

Exemption from these  State taxes is a separate matter, and how an organization goes about getting exemption from them depends on the State. Some States make exemption a default where an organization has obtained a federal tax exemption. Other States (like Texas) require that an application be filled out. There are States they don’t require the federal exemption and allow for the nonprofit entity alone to qualify  for exemption and other States require organization’s to undergo a specific review process.

It’s key that organization’s understand their tax obligations from the beginning, because failing to pay local taxes when due can result in an organization losing its entity status until back taxes are paid. This in turn jeopardizes its federal exemption status and places the organization in danger of owing the IRS certain penalties and back taxes. Also, alot of people don’t know that if the payment of taxes has been delegated to a specific person, like the Treasurer, they could find themselves personally responsible for anything that isn’t paid.


My Recommendation

What I recommend to organizations is to: i) figure out what State taxes they may be exempt from and submit the applicable applications; and ii) create some type of calendar that details when specific taxes are due to make sure payments are made. This information can generally be obtained from a State’s Comptroller site or a link is typically provided on the Attorney General’s site.  I also recommend organization’s keep a “kitty” just in case the federal exemption application is rejected or takes a substantially long time to be reviewed. There are States that don’t require State tax payments to be made until the federal application is processed, but if the application is denied may require back payments be made for taxes that would have otherwise been due. Then there are other States that may require payment where the State tax deadline comes around  and a federal exemption application is still pending.

Once you’ve navigated the jungle and managed to not only obtain federal exemption but state exemption from taxes make sure to find out whether returns still need to be filed. There are some States that require an informational return to be filed even where an exemption applies.