The Nonprofit and Tax-Exempt Organizations Toolkit

Nonprofit > Governance and Exemption | Published 13 June 2025 - Updated 21 July 2026 | UpLaw - uplaw.us

In brief. Exemption is not a status a nonprofit has. It is a set of ongoing conditions it must keep satisfying — organizational, operational, distributional, and behavioral — enforced by a federal tax agency, fifty attorneys general, and a Form 990 that anyone can read. Most failures are not fraud. They are a board that never learned which of its ordinary decisions were regulated.

Keywords: organizational test, operational test, commerciality, Form 1023, Form 990, public support, Chapter 42, self-dealing, inurement, § 4958, rebuttable presumption, § 501(h), campaign prohibition, UBIT, UPMIFA, cy pres

---

How This Toolkit Is Organized

Ten pillars, each giving the doctrine, the anchors, the trap and its second order consequence, and where to go deeper. Then the authority shelf, then two appendices: a transaction-screening matrix and an annual compliance calendar.

The narrative entry point is The Price of Exemption: Private Benefit, Excess Benefit, and the Duties of a Nonprofit Board. The doctrinal treatment is Nonprofit Governance: A Comprehensive Guide to Formation, Exemption, and Fiduciary Duty. The operational sequence is Forming a Nonprofit and Applying for Exemption: A Practical Checklist.

---

Pillar 1 — Formation and the Organizational Test

Doctrine. A § 501(c)(3) organization's governing document must limit its purposes to one or more exempt purposes, must not expressly empower it to engage in more than an insubstantial amount of non-exempt activity, and must permanently dedicate its assets to exempt purposes on dissolution.

Anchors. 26 U.S.C. § 501(c)(3); Treas. Reg. § 1.501(c)(3)-1(b). State nonprofit corporation acts (the Model Nonprofit Corporation Act and its variants); charitable trust law as an alternative form.

Trap. A purpose clause drafted by a business lawyer — broad, flexible, "any lawful purpose" — which fails the organizational test outright. So does the omission of a dissolution clause dedicating assets to another exempt organization or to government. These are the two most common reasons a Form 1023 comes back.

Trap, second order. Choosing the wrong subsection. A trade association is § 501(c)(6), a social welfare and advocacy organization is § 501(c)(4), a social club is § 501(c)(7), and only § 501(c)(3) confers deductibility of contributions while accepting the lobbying limits and the absolute campaign prohibition. Founders routinely want (c)(3) deductibility and (c)(4) political freedom, and the answer is usually a paired structure, not a single entity.

Go deeper: Guide Parts I–II

---

Pillar 2 — The Operational Test and Commerciality

Doctrine. The organization must be operated exclusively for exempt purposes — construed to mean primarily — and no more than an insubstantial part of its activities may further a non-exempt purpose.

Anchors. Treas. Reg. § 1.501(c)(3)-1(c); Better Business Bureau v. United States, 326 U.S. 279 (1945) (a single substantial non-exempt purpose defeats exemption regardless of the number or importance of exempt purposes). The commerciality doctrine: United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (7th Cir. 1999); Living Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991) (competition with commercial firms, pricing methodology, absence of donations, and commercial promotion as indicia).

Trap. Better Business Bureau's rule is stricter than it sounds: one substantial non-exempt purpose is fatal, and it is not cured by an abundance of good works. The analysis is qualitative, not a percentage.

Trap, second order. The commerciality slide. An organization that funds itself entirely through fee-for-service revenue, prices at market, advertises like a business, employs no volunteers, and accumulates surplus begins to look like a taxable business with a mission statement. This is the recurring exposure for hospitals, schools, publishers, fitness and childcare providers, and social enterprises — and the fix is structural (donative support, subsidized pricing, documented charitable class) rather than rhetorical.

Go deeper: Guide Part III

---

Pillar 3 — Exemption Application and Annual Disclosure

Doctrine. Exemption is recognized on application and maintained by annual information return, which is public.

Anchors. Form 1023 and Form 1023-EZ; Form 1024 and 1024-A for other subsections. The 27-month rule for retroactive recognition to formation. Form 990, 990-EZ, 990-N, and 990-PF; 26 U.S.C. § 6033. Automatic revocation for three consecutive years of non-filing, § 6033(j). Public inspection obligations, § 6104.

Trap. Form 1023-EZ. It is fast and cheap and it asks the organization to attest to eligibility rather than to demonstrate it. Organizations that were never eligible obtain determination letters, and the exposure surfaces at the first audit, the first grant application requiring a full 1023, or the first state registration.

Trap, second order. Form 990 is a governance document, not a tax return. Part VI asks whether the organization has a conflict of interest policy, a whistleblower policy, a document retention policy, whether the board reviewed the 990 before filing, and how compensation was determined. None of those are required by the Code — and answering "no" is a public statement that funders, journalists, and state regulators read. The 990 is frequently the most-read document the organization produces.

Go deeper: Guide Parts IV, XI · Checklist Phases 4–6

---

Pillar 4 — Public Charity or Private Foundation

Doctrine. Every § 501(c)(3) is presumed a private foundation unless it qualifies as a public charity — and the classification determines which excise taxes, deduction limits, and operating rules apply.

Anchors. 26 U.S.C. § 509(a) — (a)(1) with § 170(b)(1)(A) (churches, schools, hospitals, governmental units, and publicly supported organizations); (a)(2) (support from exempt-function revenue and contributions, with limits on investment income and disqualified-person support); (a)(3) supporting organizations (Types I, II, III functionally and non-functionally integrated); (a)(4). The one-third and ten-percent-plus-facts-and-circumstances public support tests, computed on a five-year rolling basis on Schedule A.

Trap. The tipping problem. A single very large gift can push an organization's public support ratio below the threshold and convert it to a private foundation — sometimes years after the gift, when the five-year window rolls. Model the ratio before accepting a transformative gift, and consider structuring it as a multi-year pledge or routing it through a donor-advised fund.

Trap, second order. Type III non-functionally integrated supporting organizations carry payout and notification requirements and are treated as private foundations for several purposes — including that grants to them do not count as qualifying distributions for a private foundation grantor without expenditure responsibility. Organizations adopt the supporting-organization structure for governance reasons and inherit foundation-like burdens they did not price.

Go deeper: Guide Part V

---

Pillar 5 — Private Foundations: Chapter 42

Doctrine. Private foundations operate under five excise tax regimes that convert ordinary business judgment into taxable events.

Anchors. 26 U.S.C. § 4940 (net investment income tax); § 4941 (self-dealing); § 4942 (minimum distribution — generally 5% of noncharitable-use assets); § 4943 (excess business holdings); § 4944 (jeopardizing investments); § 4945 (taxable expenditures, including lobbying, grants to individuals without advance approval, and grants to non-public-charities without expenditure responsibility).

Trap. § 4941 self-dealing is essentially strict liability, and it does not have a fairness defense. Nearly any transaction between a foundation and a disqualified person — sale, lease, loan, furnishing of goods or services, payment of compensation, transfer of assets — is self-dealing even if the terms favor the foundation. Renting office space from a trustee at below-market rent is self-dealing. Paying a disqualified person's personal pledge from foundation funds is self-dealing. The exceptions are narrow and specific.

Trap, second order. § 4945 expenditure responsibility on grants. A foundation grant to anything other than a public charity — a foreign organization, a supporting organization, a for-profit social enterprise — requires a pre-grant inquiry, a written agreement with specified terms, grantee reports, and reporting on the 990-PF. Foundations doing international or impact work routinely make these grants without the procedure and discover the taxable expenditure years later.

Go deeper: Guide Part VI

---

Pillar 6 — Inurement, Private Benefit, and § 4958

Doctrine. Three overlapping prohibitions: no part of net earnings may inure to an insider (an absolute bar with revocation as the sanction); the organization may not serve private interests more than incidentally; and an excess benefit transaction with a disqualified person triggers excise taxes on the recipient and on managers who approved it.

Anchors. § 501(c)(3) (inurement); Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii) (private benefit); 26 U.S.C. § 4958 and Treas. Reg. § 53.4958 — 25% initial tax on the excess benefit to the disqualified person, 200% if not corrected, 10% on organization managers who knowingly participated (capped), plus automatic excess benefit treatment for economic benefits not contemporaneously substantiated as compensation. United Cancer Council (a contract with an unrelated fundraiser is not inurement absent insider status).

Trap. The rebuttable presumption of reasonableness is available and routinely botched. It requires three elements: approval in advance by an authorized body without conflicted members; reliance on appropriate comparability data; and contemporaneous documentation of the basis for the determination. Approving compensation after the fact, or with the executive in the room, or on a consultant's summary nobody kept, forfeits a presumption that would have shifted the burden to the IRS.

Trap, second order. Automatic excess benefit. Any economic benefit provided to a disqualified person that the organization does not clearly indicate its intent to treat as compensation — by contemporaneous written substantiation or by reporting it on a Form W-2 or 1099 — is an excess benefit in its entire amount, regardless of whether total compensation was reasonable. Unreported personal use of a vehicle, club dues, or spousal travel becomes a 25% tax on the whole benefit.

Go deeper: Guide Parts VII–VIII · Article

---

Pillar 7 — Compensation and Conflicts

Doctrine. Compensation must be reasonable for services actually rendered, determined by a process that would satisfy § 4958, and disclosed publicly.

Anchors. § 4958 and the rebuttable presumption procedure; Form 990 Part VII and Schedule J (officers, directors, trustees, key employees, and the five highest-compensated employees over the threshold; supplemental disclosure of nonfixed payments, first-class travel, housing, and severance). 26 U.S.C. § 4960 — a 21% excise tax on remuneration over $1 million and on excess parachute payments to covered employees. State nonprofit corporation act conflict provisions and the Revised Model Nonprofit Corporation Act.

Trap. Comparability data that is not comparable. Salary surveys must match on organization size, budget, geography, sector, and role. A national survey median applied to a small regional organization is not appropriate comparability data, and the IRS says so.

Trap, second order. § 4960 catches organizations that never thought of themselves as paying large compensation, because the covered-employee designation is sticky — once an individual is among the five highest compensated, they remain a covered employee in later years — and because the tax reaches related-organization compensation in the aggregate. Health systems, universities, and large associations should model it annually.

Go deeper: Guide Part VIII

---

Pillar 8 — Lobbying and the Campaign Prohibition

Doctrine. A § 501(c)(3) may lobby, but not substantially. It may never participate or intervene in a political campaign on behalf of or in opposition to a candidate.

Anchors. § 501(c)(3) ("no substantial part"); 26 U.S.C. § 501(h) and § 4911 (the expenditure test election on Form 5768, with a sliding-scale total lobbying limit and a separate grassroots limit at one-quarter of it); § 4912 (tax on disqualifying lobbying by non-electing organizations); § 4955 (excise tax on political expenditures); § 7409 (injunctive relief). Rev. Rul. 2007-41 (facts-and-circumstances guidance on campaign intervention, voter guides, candidate appearances, and issue advocacy).

Trap. Not making the § 501(h) election. It converts a vague, revocation-backed "substantial part" standard into a bright-line dollar test with a graduated excise tax rather than loss of exemption as the first consequence, and it excludes nonpartisan analysis, responses to written requests from a legislative body, self-defense communications, and communications with members. Almost every public charity that lobbies at all should elect, and the election is a one-page form.

Trap, second order. The campaign prohibition is absolute and has no de minimis. A single endorsement from the pulpit, a candidate's uncontested appearance at an organization event, a voter guide skewed by question selection, or an executive's use of organizational channels for a candidate can support revocation and § 4955 tax. Issue advocacy timed to an election and echoing a candidate's message is the recurring gray zone; the facts-and-circumstances factors in Rev. Rul. 2007-41 are the operative test.

Go deeper: Guide Part IX · Lobbying, FARA, and Government Ethics: A Comprehensive Compliance Guide

---

Pillar 9 — Unrelated Business Income Tax

Doctrine. Income from a trade or business, regularly carried on, not substantially related to the exempt purpose (other than the need for funds), is taxable.

Anchors. 26 U.S.C. §§ 511–514. Modifications under § 512(b) — dividends, interest, royalties, certain rents from real property, and gains from disposition of property are generally excluded. Exceptions under § 513 — volunteer labor, convenience of members, sale of donated goods, qualified sponsorship payments, qualified convention and trade show activity. Debt-financed income under § 514. § 512(a)(6) siloing — UBTI computed separately for each unrelated trade or business, so losses in one silo cannot offset income in another. Form 990-T.

Trap. Royalty versus services. A passive license of a name or mark is an excluded royalty; the same arrangement becomes taxable when the organization provides endorsement services, mailing list management, or marketing support. Affinity credit card, insurance, and licensing programs live on this line, and the contract drafting determines the answer.

Trap, second order. § 512(a)(6) siloing changed the arithmetic permanently. An organization with a profitable advertising activity and a loss-generating parking operation once netted them; now each is a separate silo with separate net operating losses. Organizations that never owed UBIT before now do, and the identification of separate trades or businesses by NAICS code is a determination that should be documented rather than assumed.

Go deeper: Guide Part X

---

Pillar 10 — State Law: Fiduciary Duty, UPMIFA, and the Attorney General

Doctrine. Federal tax law governs exemption; state law governs the duties of directors, the treatment of restricted gifts, the management of endowments, solicitation, and enforcement.

Anchors. State nonprofit corporation acts; duties of care, loyalty, and obedience to purpose; the business judgment rule as applied to nonprofit boards. UPMIFA — prudent management and the seven factors, the elimination of the historic-dollar-value floor, standards for appropriation from an endowment, and release or modification of restrictions (donor consent; court approval with AG notice; small-and-old-fund administrative release). Cy pres and equitable deviation for charitable trusts. Charitable solicitation registration in the great majority of states, the Unified Registration Statement, and professional fundraiser registration and contract requirements. Riley v. National Federation of the Blind, 487 U.S. 781 (1988) (First Amendment limits on fundraising cost regulation). Americans for Prosperity Foundation v. Bonta, 594 U.S. 595 (2021) (compelled disclosure of major donors to a state regulator invalidated on associational grounds).

Trap. Donor restrictions are enforceable and durable. A gift accepted for a stated purpose creates a restriction that binds indefinitely; it cannot be released by board vote, and spending restricted funds for general operations is a breach of trust — one of the most common bases for attorney general intervention. Fix it at the gift agreement stage with a variance or alternative-use clause, which costs nothing at the time and is unobtainable later.

Trap, second order. Solicitation registration. Fundraising in a state — including through a website that solicits nationally, under the Charleston Principles framework many states apply — triggers registration, annual renewal, and financial reporting. Organizations discover this when a grantmaker's compliance team asks for the registration number they do not have, and the cure requires back-filing in every state.

Go deeper: Guide Parts XII–XIII

---

The Authority Shelf

Internal Revenue Code

• § 501(c)(3); § 501(c)(4), (c)(6), (c)(7); § 501(h); § 502; § 507; § 509
• § 170 (charitable deduction; § 170(b)(1)(A) categories; substantiation under § 170(f)(8) and (f)(11))
• §§ 511–514 (UBIT, including § 512(a)(6) siloing and § 514 debt-financed income)
• § 4940; § 4941; § 4942; § 4943; § 4944; § 4945 (Chapter 42)
• § 4911; § 4912; § 4955 (lobbying and political expenditures)
• § 4958 (excess benefit); § 4960 (excess compensation); § 4966–4967 (donor advised funds); § 4968 (endowment excise)
• § 6033 (annual returns; automatic revocation); § 6104 (public inspection); § 6113; § 7428 (declaratory judgment on exemption)

Regulations and administrative guidance

• Treas. Reg. §§ 1.501(c)(3)-1 (organizational and operational tests), 1.509(a)-1 through -7, 1.170A-9 (public support), 53.4941 through 53.4958, 1.513-1, 1.512(a)-6
• Rev. Proc. 2023-5 (and successors) — exemption application procedures; Rev. Proc. for user fees
• Rev. Rul. 2007-41 (campaign intervention); Rev. Rul. 69-545 (community benefit standard for hospitals); Rev. Rul. 98-15 and Rev. Rul. 2004-51 (joint ventures)
• IRS Exempt Organizations Continuing Professional Education texts; the Instructions to Form 990 (a substantive source of governance expectations)

Uniform and model state law

• Uniform Prudent Management of Institutional Funds Act (UPMIFA)
• Model Nonprofit Corporation Act (Third and Fourth Editions); Revised Model Nonprofit Corporation Act
• Uniform Supervision of Trustees for Charitable Purposes Act; Uniform Trust Code §§ 405–414 (charitable trusts, cy pres, small trust termination)
• Charleston Principles on internet charitable solicitation

Leading cases

• Better Business Bureau v. United States, 326 U.S. 279 (1945) · Bob Jones University v. United States, 461 U.S. 574 (1983) (public policy limitation) · Regan v. Taxation With Representation, 461 U.S. 540 (1983) (lobbying limits upheld; (c)(3)/(c)(4) pairing) · Riley v. National Federation of the Blind, 487 U.S. 781 (1988) · Living Faith, Inc. v. Commissioner, 950 F.2d 365 (7th Cir. 1991) · United Cancer Council, Inc. v. Commissioner, 165 F.3d 1173 (7th Cir. 1999) · Branch Ministries v. Rossotti, 211 F.3d 137 (D.C. Cir. 2000) · Americans for Prosperity Foundation v. Bonta, 594 U.S. 595 (2021)

Secondary sources

• Bruce R. Hopkins, The Law of Tax-Exempt Organizations — the standard treatise
• Hopkins, The Tax Law of Charitable Giving; The Law of Fundraising
• Marion Fremont-Smith, Governing Nonprofit Organizations: Federal and State Law and Regulation — the best account of the state law layer
• James J. Fishman & Stephen Schwarz, Nonprofit Organizations: Cases and Materials
• The Exempt Organization Tax Review; Nonprofit and Voluntary Sector Quarterly
• National Association of State Charity Officials (NASCO) materials; state attorney general charities bureau guidance
• BoardSource governance materials; Independent Sector Principles for Good Governance and Ethical Practice

---

Appendix A — Transaction Screening Matrix

Run every proposed board action through these questions before the vote.

Proposed action	Screen for	Governing rule
Compensating an officer or key employee	Reasonableness; conflicted approvers; comparability data; contemporaneous documentation	§ 4958 rebuttable presumption; § 4960 if over $1M
Any benefit to a director, officer, founder, or family member	Self-dealing if a private foundation; excess benefit if a public charity	§ 4941 (strict); § 4958
Renting space from, or to, an insider	Self-dealing even on favorable terms (foundation)	§ 4941
Paying an insider's personal pledge	Self-dealing / excess benefit	§ 4941; § 4958
Providing a vehicle, club dues, spousal travel	Automatic excess benefit unless contemporaneously substantiated as compensation	Treas. Reg. § 53.4958-4(c)
Accepting a transformative gift	Tipping the public support ratio	§ 509(a)(1)/(a)(2); Schedule A
Accepting a restricted gift	Enforceability; variance clause; UPMIFA appropriation	State law; UPMIFA
Spending from an endowment	UPMIFA prudence factors; donor restriction terms	UPMIFA
Releasing or modifying a restriction	Donor consent, court order with AG notice, or small-and-old-fund release	UPMIFA; cy pres
Starting a revenue-generating activity	Relatedness; regularly carried on; separate silo	§§ 511–514; § 512(a)(6)
Licensing the organization's name	Royalty exclusion versus taxable services	§ 512(b)(2)
Borrowing to acquire income-producing property	Debt-financed income	§ 514
Lobbying on legislation	§ 501(h) limits; grassroots sublimit; reporting	§ 501(h); § 4911
Anything touching a candidate	Absolute prohibition; no de minimis	§ 501(c)(3); § 4955; Rev. Rul. 2007-41
Grant to a non-public charity or foreign organization	Expenditure responsibility (foundation); equivalency determination	§ 4945
Joint venture with a for-profit	Control; whether exempt purposes are furthered	Rev. Rul. 98-15; Rev. Rul. 2004-51
Fundraising in a new state	Solicitation registration; professional fundraiser contract terms	State charitable solicitation acts

---

Appendix B — Annual Compliance Calendar

When	Obligation
Within 27 months of formation	File Form 1023 for retroactive recognition to the date of formation
Before first use of a lobbying budget	File Form 5768 to make the § 501(h) election
Annually, before compensation is set	Independent, unconflicted approval + comparability data + contemporaneous documentation for every disqualified person
Annually	Conflict of interest disclosure statements from every director and officer; review against transactions
Annually	Board review of the Form 990 before filing (Part VI asks whether this happened)
4½ months after fiscal year end	Form 990 / 990-EZ / 990-N / 990-PF due (with extensions available)
Same	Form 990-T if gross UBI is $1,000 or more, computed per silo
Annually	Private foundations: verify § 4942 minimum distribution met; file 990-PF; pay § 4940 tax
Annually	Charitable solicitation registration renewals in every state where the organization solicits
Annually	State corporate annual report and registered agent confirmation
Annually	UPMIFA endowment appropriation determination, documented against the seven factors
Annually	Public support ratio computed on Schedule A; model the effect of any anticipated large gift
Each grant to a non-public charity	Expenditure responsibility pre-grant inquiry, written agreement, and grantee reports
Each gift over the substantiation threshold	Contemporaneous written acknowledgment; Form 8283 signature for noncash gifts
Every three years	Confirm no risk of automatic revocation for consecutive non-filing
On any change of purpose, name, or structure	Report on Form 990; amend governing documents; confirm dissolution clause survives
Continuously	Public inspection: Forms 1023, 990 (three years), and 990-T available on request and on the website

---

Related Documents

Articles

• The Price of Exemption: Private Benefit, Excess Benefit, and the Duties of a Nonprofit Board
• Registering to Ask: Lobbying Disclosure, FARA, and the Line Between Advocacy and Agency
• The Trustee's Year: What Fiduciary Duty Looks Like in Practice

Guides

• Nonprofit Governance: A Comprehensive Guide to Formation, Exemption, and Fiduciary Duty
• Lobbying, FARA, and Government Ethics: A Comprehensive Compliance Guide
• Trust Administration: A Comprehensive Guide to Trustee Duties, Distributions, and Modification
• Art Law: A Comprehensive Guide to Sales, Authenticity, Moral Rights, and Cultural Property

Checklists

• Forming a Nonprofit and Applying for Exemption: A Practical Checklist
• Registering and Reporting as a Lobbyist: A Practical Compliance Checklist
• Running a Conflicts Check: A Practical Checklist

Toolkits

• The Political Law and Government Ethics Toolkit
• The Trust Administration and Fiduciary Litigation Toolkit
• The Employee Benefits and Executive Compensation Toolkit