Yes, nonprofits pay taxes. A 501(c)(3) organization is exempt from federal income tax on revenue tied to its charitable mission, but that exemption is narrower than the label suggests. Nonprofits still owe payroll taxes on their employees, they can owe state sales and property taxes, and they pay a flat 21% federal tax on income from activities unrelated to their exempt purpose. Private foundations pay additional excise taxes on top of that. The distance between “tax-exempt” and “tax-free” is where most compliance problems start.
Payroll Taxes Every Nonprofit With Employees Owes
Tax-exempt status does not waive any employment tax obligation. A nonprofit that pays wages must withhold federal income tax from paychecks and must withhold and match FICA contributions, which fund Social Security and Medicare. Employer and employee each pay 6.2% for Social Security on earnings up to the 2026 wage base of $184,500, plus 1.45% for Medicare on all earnings, for a combined 7.65% per side.1Social Security Administration. Contribution and Benefit Base A nonprofit paying a $100,000 salary owes $7,650 in employer-side FICA before any other payroll cost.
Federal unemployment tax depends on the type of nonprofit. Organizations that are not 501(c)(3) entities pay FUTA at 6.0% on the first $7,000 of each employee’s annual wages, though state unemployment credits typically bring the effective rate down to 0.6%.2Internal Revenue Service. Topic No. 759, Form 940 – Employers Annual Federal Unemployment (FUTA) Tax Return Section 501(c)(3) organizations are exempt from FUTA itself, but they still have to participate in their state’s unemployment system. They either pay state unemployment contributions like any other employer or elect the reimbursement method, repaying the state dollar-for-dollar for unemployment benefits paid to former employees.3Internal Revenue Service. Exempt Organizations – What Are Employment Taxes
Worker Classification Costs
One of the most expensive payroll errors is treating workers as independent contractors when they should be employees. The IRS looks at three categories: whether the organization controls how the work gets done, whether it controls financial aspects like reimbursement and payment method, and whether the arrangement resembles employment through benefits or ongoing engagement.4Internal Revenue Service. Independent Contractor (Self-Employed) or Employee? No single factor decides it. Getting the classification wrong makes the organization liable for unpaid employment taxes plus penalties and interest, and can put its exempt status under scrutiny.
Unrelated Business Income Tax
The federal income tax nonprofits most often actually pay is on unrelated business income. When a tax-exempt organization earns revenue from a commercial activity unconnected to its charitable mission, that income is taxed at the flat 21% corporate rate.5Internal Revenue Service. Unrelated Business Income Defined The point of the rule is to keep nonprofits from gaining an unfair competitive edge over for-profit businesses running the same activities.
Income qualifies as unrelated business income only if it meets a three-part test. It must be a trade or business, meaning it produces income from selling goods or performing services. It must be regularly carried on, with a frequency comparable to a similar for-profit operation. And it must not be substantially related to the organization’s exempt purpose.5Internal Revenue Service. Unrelated Business Income Defined All three conditions must be met.
A museum that runs a parking garage open to the general public year-round earns unrelated business income from that garage, even though the museum itself is educational. A hospital that operates a retail pharmacy selling to walk-in customers unrelated to patient care generates unrelated business income from those sales. The test looks at the connection between the activity and the mission, not at where the money ends up.
Exclusions That Protect Common Revenue Sources
Several categories of income are carved out of the unrelated business income rules, and they cover a significant share of what nonprofits actually earn:
- Passive investment income. Dividends, interest, royalties, and most rents from real property are excluded.
- Volunteer-run activities. If substantially all the work is performed by unpaid volunteers, the income is not taxable. A volunteer-staffed bake sale or fundraising event fits here.
- Sales of donated merchandise. A thrift store selling donated clothes and household goods is not generating unrelated business income.
These exclusions apply broadly across exempt organization types.6Internal Revenue Service. Unrelated Business Income Tax Exceptions and Exclusions Documentation matters. An organization claiming the volunteer labor exclusion needs records showing that volunteers performed the work, not just a general assertion.
Debt-Financed Property
Income from property bought with borrowed money can also produce unrelated business income tax, even when the income type would otherwise be excluded. Rental income is normally exempt, but if a nonprofit buys a building with a mortgage and leases it out, a portion of the rent becomes taxable. The taxable percentage equals the ratio of outstanding debt to the property’s adjusted basis.7Office of the Law Revision Counsel. 26 USC 514 – Unrelated Debt-Financed Income As the mortgage is paid down, the taxable portion shrinks. Property used substantially for the exempt purpose is excluded from these rules.
Filing Form 990-T
Any exempt organization with gross unrelated business income of $1,000 or more in a tax year must file Form 990-T, even if deductions wipe out the tax entirely. Net unrelated business income is calculated by subtracting deductions directly connected to the unrelated activity. Late filing brings a penalty of 5% of the unpaid tax for each month the return is overdue, up to 25%. Returns more than 60 days late face a minimum penalty of $525 or the full amount of tax due, whichever is less.8Internal Revenue Service. Instructions for Form 990-T
State and Local Taxes
Federal tax-exempt status does not carry over automatically to state or local taxes. Each layer of government has its own exemption process, and skipping any of them can produce unexpected bills.9Internal Revenue Service. Federal Tax Obligations of Nonprofit Corporations
Sales Tax
Most states that impose a sales tax require nonprofits to apply separately for a state-issued exemption certificate before making tax-free purchases. Showing a federal determination letter at checkout is not enough in most places. Even with a valid certificate, the exemption often covers only purchases directly related to the charitable purpose, not everything the organization buys.
There is also a collection side that catches organizations off guard. When a nonprofit sells goods or services, such as merchandise in a gift shop or admission to an event, it may be required to collect and remit sales tax on those transactions. The fact that the revenue supports a charitable mission does not exempt the sale from tax in most states. Organizations making regular retail sales need to register as vendors with their state tax authority.
Property Tax
Property tax exemptions are granted at the county or municipal level, not by the IRS. The organization has to apply locally and show that the property is used primarily for its exempt purpose. A nonprofit that owns a building and leases part of it to a commercial tenant may lose the exemption on the leased portion. Failing to apply means paying the full property tax bill, and retroactive exemptions are rarely available.
Private Foundation Excise Taxes
Private foundations face taxes that public charities do not. A public charity draws broad support from the general public and must receive at least one-third of its support from public contributions, or meet a facts-and-circumstances test, over a rolling five-year period.10Internal Revenue Service. Exempt Organizations Annual Reporting Requirements – Form 990, Schedules A and B: Public Charity Support Test A private foundation is typically funded by a single donor, family, or corporation, and it operates under stricter tax rules as a result.
Every private foundation pays a 1.39% excise tax on its net investment income each year, regardless of how that income is used.11Office of the Law Revision Counsel. 26 USC 4940 – Excise Tax Based on Investment Income The tax covers capital gains, dividends, interest, and rents from the foundation’s investment portfolio. It applies whether the foundation distributes every dollar of investment earnings or not.
Foundations also have to distribute at least 5% of the fair market value of their non-charitable-use assets each year for qualifying charitable purposes. Falling short triggers an initial excise tax of 30% on the undistributed amount, and if the shortfall is not corrected by the end of the taxable period, an additional 100% tax applies to whatever remains undistributed.12Office of the Law Revision Counsel. 26 USC 4942 – Taxes on Failure to Distribute Income Those escalating penalties make the 5% payout rule one of the most aggressively enforced provisions in foundation tax law.
Private foundations are also prohibited from engaging in financial transactions with “disqualified persons,” a category that includes substantial contributors, foundation managers, and their family members. Prohibited transactions include sales or leases of property, loans, payment of unreasonable compensation, and transfers of foundation assets for personal benefit.13Office of the Law Revision Counsel. 26 USC 4941 – Taxes on Self-Dealing The rules here are stricter than for public charities. Nearly any financial exchange between the foundation and a disqualified person triggers penalties, regardless of whether the terms are fair.
What Happens if a Nonprofit Skips Its Filings
Nearly every tax-exempt organization must file an annual information return with the IRS, even if it owes no tax. The form depends on the organization’s size:
- Gross receipts normally $50,000 or less: Form 990-N, the electronic postcard.
- Gross receipts under $200,000 and total assets under $500,000: Form 990-EZ or the full Form 990.
- Gross receipts of $200,000 or more, or total assets of $500,000 or more: the full Form 990.
Both revenue and asset thresholds matter for the middle tier. An organization with $150,000 in gross receipts but $600,000 in assets files the full Form 990, not the shorter version.14Internal Revenue Service. Form 990 Series – Which Forms Do Exempt Organizations File
The penalty for skipping this obligation is automatic. An organization that fails to file the required Form 990, 990-EZ, 990-PF, or 990-N for three consecutive years loses its federal tax-exempt status by operation of law. There is no warning and no discretionary decision; revocation happens on the filing due date of the third missed return.15Internal Revenue Service. Automatic Revocation of Exemption The IRS publishes a searchable list of revoked organizations.
Reinstatement requires filing a new application for exempt status and paying the applicable user fee, even if the organization was never required to apply in the first place. In most cases the reinstated exemption takes effect on the date the application is submitted, though the IRS will grant retroactive reinstatement to the original revocation date under limited circumstances.16Internal Revenue Service. Reinstatement of Tax-Exempt Status After Automatic Revocation Between revocation and reinstatement, the organization is treated as a taxable entity, and donations to it are not deductible.
Intermediate Sanctions on Insiders
No part of a 501(c)(3) organization’s net earnings can benefit private individuals, including founders, board members, and executives. Compensation is allowed; it just has to be reasonable for the services performed. Sweetheart deals, below-market loans to insiders, or bonuses unrelated to any work all violate this rule.
When an insider receives an excess benefit from a transaction with a tax-exempt organization, the IRS can impose “intermediate sanctions” rather than jumping straight to revocation. The person who received the excess benefit owes an excise tax of 25% of the excess amount. If that person fails to return the excess benefit within the correction period, the tax escalates to 200% of the excess. Organization managers who knowingly approved the transaction can face a separate 10% tax, capped at $20,000 per transaction.17Internal Revenue Service. Intermediate Sanctions – Excise Taxes These penalties hit individuals personally, not the organization’s accounts.