What Is a 501(c)(3) Organization?

Section 501(c)(3) is a portion of the U.S. Internal Revenue Code (IRC) and a specific tax category for nonprofit organizations. Organizations that meet Section 501(c)(3) requirements are exempt from federal income tax. While the Internal Revenue Service (IRS) recognizes more than 30 types of nonprofit organizations, only those that qualify for 501(c)(3) status can say that donations to them are tax deductible.

Most of the organizations that may be eligible for 501(c)(3) designation fall into one of three categories: charitable organizations, churches and religious organizations, and private foundations. The rules outlined in Section 501(c)(3) are regulated by the U.S. Treasury through the IRS.

How a 501(c)(3) Organization Works

To be considered a charitable organization by the IRS, a group must operate exclusively for one of these purposes: charitable, religious, educational, scientific, literary, testing for public safety, fostering national or international amateur sports competition, or preventing cruelty to children or animals.

Furthermore, the IRS defines “charitable” activities as “relief of the poor, the distressed, or the underprivileged; advancement of religion; advancement of education or science; erecting or maintaining public buildings, monuments, or works; lessening the burdens of government; lessening neighborhood tensions; eliminating prejudice and discrimination; defending human and civil rights secured by law; and combating community deterioration and juvenile delinquency.”

Requirements of a 501(c)(3) Organization

To be tax exempt under Section 501(c)(3), an organization must not be serving any private interests, including the interests of the creator, the creator’s family, shareholders of the organization, other designated individuals, or other persons controlled by private interests. None of the net earnings of the organization can be used to benefit any private shareholder or individual; all earnings must be used solely for the advancement of its charitable cause.

A 501(c)(3) organization is also forbidden from using its activities to influence legislation in a substantial way, including participating in any campaign activities to support or deny any particular political candidate. It is typically not permitted to engage in lobbying (except in instances when its expenditures are below a certain amount).

People employed by the organization must be paid “reasonable compensation,” which is based on the fair market value that the job function requires.

To remain tax exempt under Section 501(c)(3), an organization is also required to remain true to its founding purpose. If an organization has previously reported to the IRS that its mission is to help less privileged individuals gain access to a college education, it must maintain this purpose. If it decides to engage in another calling—for example, sending relief to displaced families in poverty-stricken countries—the 501(c)(3) organization has to first notify the IRS of its change of operations to prevent the loss of its tax-exempt status.

While some unrelated business income is allowed for a 501(c)(3) organization, the tax-exempt charity may not receive substantial income from unrelated business operations. This means that the majority of the firm’s efforts must go toward its exempt purpose as a nonprofit organization. Any unrelated business from sales of merchandise or rental properties must be limited or the organization could lose its 501(c)(3) status. While the IRS doesn’t specify exactly how much is too much unrelated business income, the law firm of Hurwit & Associates, which specializes in representing nonprofits, estimates the amount at somewhere between 15% and 30%.

While organizations that meet the requirements of Section 501(c)(3) are exempt from federal income tax, they are required to withhold federal income tax from their employees’ paychecks and pay Social Security and Medicare taxes. They do not, however, have to pay federal unemployment taxes.

Special Considerations

Organizations that meet the 501(c)(3) tax category requirements can be classified into two categories: public charities and private foundations. The main distinction between these two categories is how they get their financial support. 

Public Charity

A public charity is a nonprofit organization that receives a substantial portion of its income or revenue from the general public or the government. At least one-third of its income must be received from the donations of the general public (including individuals, corporations, and other nonprofit organizations).

If an individual donates to an organization that the IRS considers to be a public charity, they may qualify for certain tax deductions that can help them lower their taxable income. Generally, the total amount of donations to a tax-exempt public charity that an individual can claim is limited to 50% of their adjusted gross income (AGI). However, there is no limitation on donations to qualified charitable organizations, such as a 501(c)(3).

Private Foundation

A private foundation is typically held by an individual, a family, or a corporation and obtains most of its income from a small group of donors. Private foundations are subject to stricter rules and regulations than public charities. All 501(c)(3) organizations are automatically classified as private foundations unless they can prove they meet the IRS standards to be considered a public charity. The deductibility of contributions to a private foundation is more limited than donations for a public charity.

To apply for tax-exempt status under Section 501(c)(3), most nonprofit organizations are required to file Form 1023 or Form 1023-EZ within 27 months from their date of incorporation. The charitable organization must include its articles of incorporation and provide documents that prove that the organization is only operating for exempt purposes.

However, not all organizations that qualify for the tax category need to submit Form 1023. For example, public charities that earn less than $5,000 in revenue per year are exempt from filing this form. Even though it is not required, they may still choose to file the form to ensure that donations made to their organization will be tax deductible for donors.

Advantages and Disadvantages of a 501(c)(3) Organization

The 501(c)(3) status offers a myriad of benefits to the designated organizations and the people they serve. For starters, 501(c)(3) organizations are exempt from paying federal income and unemployment taxes, and patrons who donate to them are allowed to claim a tax deduction for their contributions.

To help with funding and further their mission, these organizations are eligible to receive government and private grants. To qualify, the organization must have a mission aligned with the purpose of the grant and a need for it. In addition, 501(c)(3) organizations often receive discounts from retailers, free advertising by way of public service announcements, and food and supplies from other nonprofit organizations designed to help in times of need.

A 501(c)(3) could be the lifelong dream of its founder; however, once established as a 501(c)(3), it no longer belongs to its founder. Rather, it is a mission-oriented organization belonging to the public. To maintain its favorable tax treatment, it must operate within the confines of the law pertaining to 501(c)(3) organizations.

Because the organization serves the public, it must operate with full transparency. Therefore, its finances, including salaries, are available to members of the public and subject to their review.

Example of a 501(c)(3) Organization

The American Red Cross, established in 1881 and congressionally chartered in 1900, is one of the United States’ oldest nonprofit organizations. Its mission statement says that the Red Cross “prevents and alleviates human suffering in the face of emergencies by mobilizing the power of volunteers and the generosity of donors.” Since its inception, its goal has been to serve members of the armed forces and provide aid during disasters.

Located in 191 countries, the Red Cross operates the largest network of volunteers in the world. This 501(c)(3) organization is segmented into three divisions: the National Red Cross and Red Crescent Societies, the International Federation of Red Cross and Red Crescent Societies, and the International Committee of the Red Cross.

The National Red Cross and Red Crescent Societies, which include the American Red Cross, aim to relieve human suffering globally by empowering subordinate organizations to operate within their nation’s borders to provide disaster relief, education, and other related services. The International Federation of Red Cross and Red Crescent Societies provides global humanitarian aid during peacetime, such as assisting refugees. The International Committee of the Red Cross provides humanitarian relief for people affected by war or other armed conflicts.

People who itemize their tax deductions can contribute to the Red Cross and claim the amount donated as a deduction. Taxpayers who use the standard deduction may still claim up to $600 of their 501(c)(3) contributions as a tax deduction in 2021.

The Bottom Line

501(c)(3) organizations are nonprofit groups with a dedicated mission. Most people are familiar with them as churches and charities, but they also include private foundations. As long as they operate to support their mission, they receive favorable tax treatment, such as avoiding federal income and unemployment taxes.

What Is Annualized Income?

Annualized income is an estimate of the sum of money that an individual or a business generates over a year’s time. Annualized income is calculated with less than one year’s worth of data, so it is only an approximation of total income for the year. Annualized income figures can be helpful for creating budgets and making estimated income tax payments.

Understanding Annualized Income

Annualized income can be calculated by multiplying the earned income figure by the ratio of the number of months in a year divided by the number of months for which income data is available. If, for example, a consultant earned $10,000 in January, $12,000 in February, $9,000 in March and $13,000 in April, the earned income figure for those four months totals $44,000. To annualize the consultant’s income, multiply $44,000 by 12/4 to equal $132,000.

How Estimated Tax Payments Work

Taxpayers pay annual tax liabilities through tax withholdings and by making estimated tax payments each quarter. There are many sources of income that are not subject to tax withholding. Income from self-employment, interest and dividend income and capital gains are not subject to tax withholdings, along with alimony and some other sources of income that may be reported to a taxpayer on Form 1099. To avoid a penalty for tax underpayment, the total tax withholdings and estimated tax payments must equal to the lesser of 90% of the tax owed for the current year or the full tax owed the previous year.

Examples of Annualized Income That Fluctuates

Computing estimated tax payments is difficult if the taxpayer’s income sources fluctuate during the year. Many self-employed people generate income that varies greatly from one month to the next. Assume, for example, that a self-employed salesperson earns $25,000 during the first quarter and $50,000 in the second quarter of the year. The higher income in the second quarter indicates a higher total level of income for the year, and the first quarter’s estimated tax payment is based on a lower level of income. As a result, the salesperson may be assessed an underpayment penalty for the first quarter.

Factoring in the Annualized Income Installment Method

To avoid the underpayment penalties due to fluctuating income, the IRS Form 2210 allows the taxpayer to annualize income for a particular quarter and compute the estimated tax payments based on that amount. Schedule AI of Form 2210 provides a column for each quarterly period, and the taxpayer annualizes the income for that period and computes an estimated tax payment based on that estimate. Using the salesperson example, Form 2210 allows the taxpayer to annualize the $25,000 first quarter income separately from the $50,000 second quarter income.

What Is an A-B Trust?

An A-B trust is a joint trust created by a married couple for the purpose of minimizing estate taxes. It is formed with each spouse placing assets in the trust and naming as the final beneficiary any suitable person except the other spouse. The trust gets its name from the fact that it splits into two separate entities when one spouse dies. Trust A is the survivor’s trust and trust B is the decedent’s trust.

Understanding an A-B Trust

Estate taxes can bite deeply into a deceased person’s assets. For example, consider a married couple that has an estate worth $20 million by the time one of the spouses dies. The surviving spouse is left with the whole $20 million, which is not taxed due to the unlimited marital deduction for assets flowing from a deceased spouse to a surviving spouse.

But then, the other spouse dies, leaving the money to their children. The taxable portion of the estate (the amount that exceeds the 2022 exemption threshold of $12.06 million will be $7.94 million). This means that $7.94 million will be taxed at 40%, leaving only $4.76 million for the beneficiaries. The exemption for 2023 is $12.92 million.

To circumvent the estate from being subject to such steep taxes, many married couples set up a trust under their last will and testaments called an A-B trust. In the example above, if the couple instead had an A-B trust, the death of the first spouse would not trigger any estate taxes as a result of the lifetime exclusion; however, a sum of money equal to the current exemption amount will be transferred into an irrevocable trust called the bypass trust or B trust.

This trust is also known as the decedent’s trust. The remaining amount, $7.94 million, will be transferred to a survivor’s trust, or A trust, which the surviving spouse will have complete control over. The estate tax on the A trust is deferred until after the death of the surviving spouse.

Benefits of an A-B Trust

The A trust contains the surviving spouse’s property interests, but they have limited control over the assets in the deceased spouse’s trust; however, this limited control over the B trust will still enable the surviving spouse to live in the couple’s house and draw income from the trust, provided these terms are stipulated in the trust.

While the surviving spouse can access the bypass trust, if necessary, the assets in this trust will bypass their taxable estate after they die. After the surviving spouse dies, only the assets in the A trust are subject to estate taxes. If the estate tax exemption for this spouse is also $12.06 million for 2022 (the exemption threshold for 2023 is $12.92 million) and the value of assets in the survivor’s trust is still valued at $7.94 million, none of it will be subject to estate tax.

The federal tax exemption is transferable between married couples through a designation referred to as the portability of the estate tax exemption. If one spouse dies, the unused portion of their estate tax exemption can be transferred and added to the estate tax exemption of the surviving spouse. Upon the death of the surviving spouse, the property in the decedent’s trust passes tax-free to the beneficiaries named in this trust.

This is because the B trust uses up the estate tax exemption of the spouse that died first, hence, any funds left in the decedent’s trust will be passed tax-free. As the decedent’s trust is not considered part of the surviving spouse’s estate for purposes of the estate tax, double taxation is avoided.

Net Worth and A-B Trusts

If the deceased spouse’s estate falls under the amount of their tax exemption, then it may not be necessary to establish a survivor’s trust. The unused portion of the late spouse’s federal tax exemption can be transferred to the surviving spouse’s tax exemption by filling out IRS Form 706.

While A-B trusts are a great way to minimize estate taxes, they are not used much today. They were popular in the decades around the turn of the 21st century when the estate tax—which hadn’t been adjusted for years—could be triggered on estates as small as $1 million or $2 million. Nowadays, each individual has a combined lifetime federal gift tax and estate tax exemption of $12.06 million in 2022, rising to $12.92 million in 2023.

So only people with estates valued over $12.06 million will opt for an A-B trust in 2022. With the portability provision, a surviving spouse can include the tax exemption of their late spouse, allowing up to $24.12 million as of 2022 and $25.84 million in 2023, which can be transferred tax-free to beneficiaries.

What Is the American Opportunity Tax Credit (AOTC)?

The American Opportunity Tax Credit (AOTC) is a tax credit for qualified education expenses associated with the first four years of a student’s postsecondary education. The maximum annual credit is $2,500 per eligible student. The student, someone claiming the student as a dependent, or a spouse making postsecondary education payments can claim the AOTC on their tax return.

Understanding the American Opportunity Tax Credit (AOTC)

With the AOTC, a household with a qualifying student can receive a maximum $2,500 tax credit per year for the first four years of higher education. Parents claiming a dependent child who is a full-time student ages 19 to 24 can claim an additional $500 Child Tax Credit.

The AOTC helps with educational costs such as tuition and other expenses related to a student’s coursework. Eligible students (or their parents) can claim 100% of the first $2,000 spent on school expenses and 25% of the next $2,000. This comes out to a maximum credit of $2,500: (100% × $2,000) + (25% × $2,000).

In general, tax credits are refundable, nonrefundable, or partially refundable. Up to $1,000 (40%) of the AOTC is refundable, making it a partially refundable tax credit. So, if the credit brings your tax liability to $0, you can receive 40% of your eligible credit (up to $1,000) as a refund.

AOTC Eligibility Requirements

Like other tax credits, you must meet specific eligibility requirements to claim the AOTC.

Who Can Claim the AOTC?

To claim the AOTC on your tax return, you must meet all three of these requirements:

• You pay qualified education expenses for higher education.
• You pay the education expenses for an eligible student.
• The eligible student is either you, your spouse, or a dependent whom you claim on your tax return.

Additionally, you must receive Internal Revenue Service (IRS) Form 1098-T to claim the credit. Here’s an example of a completed form:

Source: Internal Revenue Service

Which Students Qualify for the AOTC?

A student is eligible for the AOTC only if they meet certain requirements. Specifically, the student must:

• Be taking courses toward a degree or some other recognized education qualification
• Be enrolled at least part time for at least one academic period beginning in the tax year
• Not have finished the first four years of higher education at the beginning of the tax year
• Not have claimed the AOTC (or the former Hope credit) for more than four tax years
• Not have a felony drug conviction at the end of the tax year

Which Expenses Qualify for the AOTC?

For the purposes of the AOTC, qualified education expenses include tuition and some related costs required for attending an eligible educational institution. An eligible educational institution is any accredited public, nonprofit, or private college, university, vocational school, or other postsecondary educational institution. Related expenses include:

• Student activity fees paid to the school as a condition of enrollment or attendance
• Books, supplies, and equipment needed for classes, whether or not you buy them from the school

You can pay for qualified education expenses with student loans. However, you can’t claim the credit if you paid for expenses with scholarships, grants, employer-provided assistance, or funds from a 529 savings plan.

What Are the Income Limits for the AOTC?

To claim the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 if married filing jointly). The credit begins to phase out above these limits and disappears entirely if your MAGI is above $90,000 ($180,000 for married filing jointly).