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Kentucky Tax Benefits for Nonprofits

Nonprofits play a vital role in our lives.  Children attend nonprofit schools and colleges.  People worship at nonprofit churches, synagogues and mosques.  The ill and injured receive medical care from nonprofit hospitals.  Those in need get assistance, often in the form of social services, from nonprofit charities including homeless shelters and counseling.  There are many other examples.

A nonprofit (sometimes also referred to as a not-for-profit) is a legal entity - often, but not always, a corporation - that is organized for some purpose other than making a profit.  Contrast a nonprofit with a classic for-profit business that exists to generate profits for the benefit of its owners.  

Nonprofit Organizations Exempt from Federal Income Tax

Traditionally, the federal government of the United States has afforded favorable income tax treatment to nonprofits.  Most tax practitioners are familiar with the exemption granted to various types of non-profits under Section 501 of the Internal Revenue Code of 1986, as amended.  Though generally exempt, these organizations are subject to tax on their unrelated business income under Sections 511 to 515 of the Code. 

When we think of tax-exempt organizations, we often think of those exempt under Section 501(c)(3) such as those “organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes….”  The Educational Foundation of the Kentucky Society of Certified Public Accountants, which awards accounting scholarships and supports accounting career initiatives, is an example.   

There are other tax-exempt organizations.  Section 501(c)(6) encompasses organizations with members who have a common business interest.  The Kentucky Society of Certified Public Accountants is but one example. 

Over the past several years, the Internal Revenue Service has increased its focus and more closely scrutinized tax-exempt organizations.  The manifestation of this focus and scrutiny can be seen in the revamped IRS Form 990 and filing requirements for smaller tax-exempt organizations. 

Kentucky Income Tax Exemption for Nonprofits

The income tax treatment afforded by the Commonwealth to nonprofits is even more generous than that afforded by the federal government.  “Corporations or other entities exempt under Section 501 of the Internal Revenue Code” are exempt from Kentucky corporation income tax under KRS 141.040(1)(f).  As if this rather broad exemption is not enough, an exemption is also provided for “[r]eligious, educational, charitable or like corporations not organized or conducted for pecuniary profit” under KRS 141.020(1)(g).  Notice the overlap from the discussion above; it would seem that most of the latter (e.g., religious, educational and charitable nonprofits) are included in the former (i.e., Section 501 of the Code). 

The most significant difference between the federal and the Kentucky income tax treatment of tax-exempt organizations is that Kentucky does not tax the unrelated business income of these organizations, unlike other states.  Consequently, a quick review of Kentucky income tax cases discloses none involving 501(c) organizations. 

Application of Kentucky Sales and Use Tax to Nonprofits

Nonprofits also receive favorable sales and use tax treatment.  To this point, the Commonwealth has provided an exemption from Kentucky sales and use tax on sales of tangible personal property, digital property and services to “resident, nonprofit educational, charitable and religious institutions” that qualify as tax-exempt organizations under Section 501(c)(3) of the Code.  KRS 139.495.  The purchase must be for use solely within the nonprofit’s educational, charitable or religious function.  See KRS 139.495(1).  Compared to the broadly drawn Kentucky income tax exemption, however, the sales and use tax exemption applies much more specifically. 

One curious aspect of this exemption is that it applies only to Kentucky resident educational, charitable and religious nonprofits.  What about non-Kentucky resident institutions?  Sales to these nonprofits are exempt as well under another provision, provided that the nonprofit is exempt in its state of residence.  See KRS 139.470(10). 

As an aside, Kentucky retailers making otherwise taxable sales that are exempt are required to collect and retain documentation that demonstrates the propriety of the exemption, e.g., exemption certificates, etc.  This documentation should be retained in the retailer’s files so that it is available in the event of a Kentucky Department of Revenue sales tax audit. 

Although certain nonprofits are exempt from sales and use tax on their purchases as discussed above, all nonprofits must collect sales tax when they make sales of non-exempt tangible personal property, digital property and taxable services.  This is a trap that nonprofits can easily fall into. 

In other words, a nonprofit making sales at retail must collect sales tax just like a for-profit retailer.  See KRS 139.495(7).  As one might expect, there are some exemptions from sales tax directed primarily to nonprofits, such as: sales of food to students in school cafeterias and lunchrooms; sales by school bookstores of textbooks, workbooks and other course materials; and, sales by nonprofit, school-sponsored clubs and organizations, but athletic event tickets are taxable!  KRS 139.495(2)-(4). 

Nonprofits that routinely sell donated items can get a refund of 25% of the tax collected on sales of donated goods if the refund is used as reimbursement for capital construction costs of additional retail locations in Kentucky.  See KRS 139.495(5)-(6).  This is a very generous benefit. 

Kentucky Property Tax Exemptions for Nonprofits

Section 170 of the Kentucky Constitution exempts specified property of certain types of nonprofits from tax.  Given that the Kentucky Constitution mandates the taxation of all property, this exemption is truly significant. 

Property owned by institutions of purely public charity is exempt.  Ky. Const. § 170.  The primary issue here is whether or not a given nonprofit is an institution of purely pubic charity.  Many older cases focus on this issue.  Note that qualification for this exemption is not determined by reference to Section 501 of the Code nor does the Code play a role in the other exemptions provided by Section 170. 

Exempt treatment extends to religious institutions.  “Real property owned and occupied by, and personal property both tangible and intangible owned by, institutions of religion” is exempt.  Ky. Const. § 170.  This exemption was the subject of protracted litigation in Freeman v. St. Andrew Orthodox Church, Inc., 294 S.W.3d 425 (Ky. 2009).  The issue there was not whether or not St. Andrew Orthodox Church was indeed a religious institution, as that was a given, but rather the extent to which the exemption reaches. 

Property of “institutions of education not used or employed for gain by any person or corporation” is also exempt.  Ky. Const. § 170.  Given that religious institutions often operate educational institutions, there can be some overlap. 

What’s a Nonprofit?

“Paragraph one states that I, the Devil, a not-for-profit organization, with offices in Purgatory, Hell, and Los Angeles….”  The Devil in Bedazzled (2000). 

Is a nonprofit a nonprofit for purposes of a particular tax exemption?  This is the $64,000 or sometimes, the $1,000,000 question for nonprofits.  Either an exemption applies or it does not.  Nonprofits typically budget from year to year with little carried over.  Particularly with regard to sales tax, which could be collected (if due) up front, the availability of an exemption for a particular nonprofit for a particular tax can be a huge issue.  The devil is in the details. 



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