What it means
Governments grant exemption to groups that do work they want to encourage, such as relief of poverty, education, health, religion and the arts. In return, the organisation must use its income for its stated mission and not to enrich private individuals.
The tax authority usually reviews an application before confirming the status. Being exempt from income tax does not mean the organisation is free of all taxes or paperwork.
It may still pay payroll taxes for its staff, sales taxes on certain purchases and property taxes in some places. It normally has to file regular returns or reports, and many publish their accounts so donors can see how money is used.
Finance teams in these organisations work differently from commercial companies. Instead of profit, the focus is on a surplus or deficit, on restricted funds that donors have limited to particular uses, and on showing that spending matches the mission.
Fund accounting, which tracks each pot of money separately, is common. A key nuance is income that is unrelated to the mission.
If a charity runs a regular commercial activity such as a large trading operation that has nothing to do with its purpose, the tax authority may tax the profit from it. Many organisations set up a separate trading subsidiary for these activities to protect the main body's status.
Exempt status can be lost, and regaining it afterwards is usually slow. Paying excessive benefits to insiders, engaging in prohibited political activity, or failing to file the required reports can lead the authority to withdraw the exemption, and the consequences may include back taxes and penalties.
Donors care about the status too, because it affects whether their gifts qualify for relief. In many countries gifts to an approved organisation qualify for tax relief, so donors check that it is properly recognised before giving.
Rules differ widely from country to country, so any specific decision should rest on local advice.
In practice
Real-world examples
Example 1
A local community college is recognised as exempt and does not pay income tax on its tuition fees or donations. It still pays payroll taxes for its staff, and its finance office reports annually to the tax authority. The college also publishes its accounts so that donors and students can see where the money goes.
Example 2
A professional association receives membership fees and runs a yearly conference. The conference income relates to its purpose and stays exempt, but the profit from selling advertising to unrelated businesses is treated as taxable. The association's accountant keeps the two income streams in separate ledgers to make the tax return simple.
Example 3
A food bank charity wants to hold a fundraising dinner. Its finance lead checks that ticket sales are recorded properly, that donors receive receipts for the donated portion, and that no board member gains personally from the event. She also records the costs of the dinner separately, so the board can see how much of every dollar raised reaches the food bank's mission.
Think of it
Imagine a community library where everyone chips in to buy books. Because the books are for everyone to read, the local council lets the library use the venue rent-free, meaning all collected money goes directly to buying new stories.
Case study
Seen in the real world
Riverbend Arts Trust is an illustrative, fictional charity that runs a small theatre. When it opened a busy cafe open to the general public, the cafe produced a surplus of $85,000 in its first year.
The trust's accountant warned the trustees that the cafe was not clearly part of the charitable purpose, so the surplus might be taxable. She recommended placing it in a separate subsidiary company that would pay tax and then donate its profits to the trust.
The trustees agreed, and the arrangement protected the exempt status of the trust. In this illustrative story, the cafe subsidiary later passed on its after-tax profit to fund two new school workshops. The trustees also asked the finance manager to report each year on how much income came from activities outside the mission, so the question of status was checked every year and not only when something changed.
Watch out
Common mistakes
- Believing an exempt organisation pays no taxes of any kind, when payroll, sales and property taxes can still apply.
- Assuming that any non-profit is automatically exempt, when the status usually requires an application and approval.
- Running a large unrelated business inside the main entity, which can create taxable income and put the status at risk.
Questions
People also ask
Can a tax exempt organisation make a surplus?
Yes, but the surplus must be used for the mission and not paid out to owners or insiders.
How does an organisation lose its exempt status?
Typical causes include private benefit to insiders, serious breaches of the rules, and failure to file the required returns.
Do donors always get a tax deduction?
Not always, because the rules depend on the country and on the type of organisation, so donors should check before giving.